If you’re the owner of a company, you’re probably getting paid somehow. But is your current approach the best one?
If you pay yourself too little, you’re going to struggle to make ends meet—and what’s the point of running a business if you’re not earning any money? On the other hand, if you pay yourself too much, you could negatively impact the financial health of your company.
In this post, we’ll look at a few different ways small business owners pay themselves, and which method is right for you.
Salary method vs. draw method
There are two main ways to pay yourself: The salary method and the draw method.
With the salary method, you’re regularly paid a set salary just like any other employee.
With the draw method, you can draw money from your business earning earnings as you see fit. Rather than having a regular, recurring income, this allows you to have greater flexibility and adjust how much money you get depending on how business is going.
The best method for you depends on the structure of your business and how involved you are in running the company.
Option 1: The salary method
Business owners who pay themselves a salary receive a fixed amount of money on a regular basis.
If you hate admin, you’ll like the salary method. State and federal personal income taxes are automatically deducted from your paycheck. On the personal side, earning a set salary also shows a steady source of income (which will come in handy when applying for a mortgage or anything else credit-related).
On the business side, paying yourself a straight salary makes it easier to keep track of your business capital. Instead of taking from the business account every time you need some money, you know exactly how much company money is being paid to you every month. This makes it easier to track expenses and manage cash flow.
The downside of the salary method is that you have to determine reasonable compensation that makes you happy, keeps your company operational, and isn’t double-taxed. If your compensation falls outside the “reasonable” range, it could raise flags with the IRS.
How easy is it to change your salary?
The good news about a set salary is that it’s not static and binding. You can easily change or adjust it over time so that it evolves alongside your business.
But how do you know how much to increase (or decrease) your salary?
Once you’ve reached a break-even point in the business, it’s a good idea to correlate any salary increases (or bonuses) to the performance of the business.
There are a couple of ways you can approach this:
Option 1: Lump-sum year end bonus
Take a look back at the past year and give yourself a bonus that correlates to company growth after break-even. If your company grows net profits by 15% over the course of the year, then you’d take a 15% lump-sum bonus on top of your base salary at year-end.
Option 2: Quarterly bonuses
Parcel out bonuses to yourself each quarter that correlates to company growth after break-even during that period.
Option 3: Adjust annual salary based on annual growth
If you’re not interested in the bonus route, you can always adjust your salary each year based on how your company is performing.
So if your company grew by 50% in the past year and your current salary is $70,000, you’d multiply your salary by 150% and come up with your new salary, which is $105,000 (not bad!).
How do you determine reasonable compensation?
The IRS’ golden rule on setting your compensation is that it has to be “reasonable”. According to the IRS, reasonable compensation is defined as:
“An amount that would ordinarily be paid for like services by like organizations in like circumstances.”
Translation: find other companies like yours and choose a salary similar to their founder/owner.
Here are a few other elements to look at to help you choose a salary that’s comfortable for you and acceptable in the eyes of the IRS:
- Your qualifications and relevant training
- How many years of experience you have
- The industry and scope of your work
- The size of your business
- The salary of people in similar positions
- Location and cost of living
If you score high marks on all those categories, feel free to give yourself a slightly higher than normal compensation package. You’ve earned it.
Option 2: The draw method
Also known as the owner’s draw, the draw method is when the sole proprietor or partner in a partnership takes company money for personal use.
The benefit of the draw method is that it gives you more flexibility with your wages, allowing you to adjust your compensation based on the performance of your business.
Unlike the salary method, your taxes aren’t automatically deducted. You will have to self-report any draws and pay taxes on them at tax time.
Another downside: it requires more personal tax planning, including quarterly tax estimates and self-employment taxes.
How much can you draw for yourself?
You can draw as much as you want and as many times as you want if you’re using the draw method (as long as there’s money in the account to draw from).
Just keep in mind that draws can limit the amount of cash you have available for growing your business and paying the bills.
What the draw method means for income taxes
Taxes around the draw method vary a bit based on your type of business.
Draw method income taxes as a sole proprietor
As the sole proprietor, you’re entitled to as much of your company’s money as you want. You don’t have to answer to stockholders or shareholders, leaving you free to take payments as you see fit. With that said, draws are considered personal income and are taxed as such.
Draw method income taxes in a partnership
The IRS views partnerships similar to sole proprietorships. Profit generated through partnerships is treated as personal income. But instead of one person claiming all the revenue for themselves, each partner includes their share of income (or loss, if business hasn’t been good) on their tax return. In other words, earnings are divided and taxed accordingly.
Draw method income taxes in an LLC
The rules governing Limited Liability Companies vary depending on the state, so be sure to check your state laws before moving forward. In both LLC entities (single and multiple), the business owner pays taxes from owner draws the same way they would as a sole proprietor or partner.
How to pay yourself (by entity type)
So now that you know a bit about the different options available, let’s talk about how to factor in your type of business to this equation.
There are five common business structures, and each one influences the way small business owners pay themselves.
|Type of Entity||Description||Recommended Payment Method|
|Sole Proprietorship||A business structure which has no separation from its owner. As a result, the owner assumes responsibility for any business debts.||Draw method.|
|Partnership||A business with two or more owners. Like sole proprietorships, partners also assume financial liability of their company.||Draw method, with revenue split between partners.|
|Limited Liability Company (LLC)||A business entity that exists separate from its owner or owners, meaning no individual is personally liable for the company’s debts.||Draw method. For single-member LLCs, the owner pays themselves the same as a sole proprietorship. Multi-member LLCs are paid the same as partnerships.|
|NFP (Not-for-Profit)||A tax-exempt organization that exists to further a social cause or advocate for a common point of view.||Salary method. Reasonable compensation should be approved by an authorized third-party.|
|S Corp||Incorporated entity that doesn’t pay dividends to the owners. Business owners only pay taxes on their share of the company, which is claimed on each individual’s tax return.||Salary method. Non-taxable distributions are also allowed within reason, but you can’t forego a salary for distributions.|
|C Corp||Incorporated entity where the corporation pays taxes on profits made, and the owners are taxed on dividends they receive.||Salary method. Unless you’re not actively working in the company, then you receive dividends.|
Note: With both NFP and Corporations, it’s not recommended to take frequent draws. For NFP organizations, there are strict reporting rules to make sure that the organization isn’t set up to generate profit. For owners of Corporations, there are rules to limit how much you draw—it’s not your money, it’s the company’s money.
Good payment practices: being smart about your wages
Whether you choose to draw your money or assign yourself a salary, there are a few guidelines you should follow.
Always leave enough cash for your business to operate smoothly after payments.
Don’t treat your business funds like a personal bank account. Stick to relatively equal payments if you’re on a draw method, and record your payments with payroll software (we recommend Gusto).
Account for taxes. Income and FICA taxes have to be paid regardless of the method you choose.
Making the call: How much do you pay yourself?
Sole proprietors, partners, and owners of LLCs are free to pay themselves as they wish.
But you still need to strike a balance that lets you live comfortably and doesn’t hurt your business. It’s always a good idea to talk to an accountant beforehand. They can help you calculate expenses and look at projected income, so that you can earn a good living and watch your business grow.
If you run a corporation or NFP, you have to assign yourself a reasonable salary. The IRS determines what is and isn’t reasonable salaries for CEOs and non-profit founders in order to prevent certain tax benefits from being exploited. As we mentioned earlier, you can determine what a reasonable wage is by comparing your earnings to CEOs in similar positions.
Make sure to keep a paper trail documenting your company’s performance and expenses so you can justify your wages if need be. Not sure how to do that? Check out our guide, Bookkeeping Basics for Entrepreneurs.