How to Pay Yourself a Paycheck From Your Business
As an entrepreneur and the Boss, there are always considerations for you that do not include the rest of the business. One of them is how to pay yourself, the business owner.
There are always bills for rent, utilities, and other operating expenses to take care of each month. Plus, business owners who want to retain and maintain their staff make a habit of paying the employees first.
Beyond cash flow, considerations such as Business Classification, Equity, and Salary vs. Draw, to name a few, are things to think about before you write yourself a paycheck.
My first and best piece of advice is to consult your CPA to set up your process. But here are the basics to know before you talk to your CPA so you can ask helpful questions.
Important Definitions
- Salary vs. Draw –
- For a Salary, you determine a set amount to be paid to yourself as a wage. Just like regular employee paychecks, Federal Withholding, Social Security, and Medicare contributions are withheld by the company. Employer payroll taxes apply to all paychecks.
- An Owner’s Draw is money taken out of the company either on a regular schedule or as needed. An Owner Draw is not a salary. The Owner is responsible for paying income tax on the amount taken, but employer payroll taxes are not a factor.
- Equity – An owner’s equity is equal to the Assets minus the liabilities. In other words, the remaining value you have invested in the business after all the liabilities have been subtracted. If you invest $1,000.00 and you owe $500.00, your equity is $500.00.
- Cash Flow – The amount of cash and cash equivalents (bank accounts, current assets) entering and leaving the company. The Cash Flow Statement measures how well the company generates cash to pay its debts and fund operations.
- Pass-through Entity – In a pass-through entity, your profit is reported to IRS and you using a Schedule K Form. The Schedule K is included in your personal tax return.
Business Classifications
Business Structures will provide different rules that dictate how an owner gets paid.* The following classifications are the ones you will need to choose from:
- C Corporation (C Corp) – A C Corp will file a tax return and pay taxes on net profit. After-tax earnings are retained for use in the company or used to pay shareholders a dividend. A Dividend is a source of income and included on the shareholder’s personal income tax.
- S Corporation (S Corp) – Your S Corp is a pass-through entity. (See above Definitions) Because you are not an employee of the company, you will take an Owner’s Draw for payment.
- Sole Proprietorship (Sole Prop) – You will take an Owner’s Draw. You will need to consider Owner’s Equity for this payment.
- Limited Liability Company (LLC) – The rules for your LLC will depend on the state you live in and can differ from State to State. An LLC can be taxed as a Sole Proprietorship, a Partnership, or a Corporation. An LLC is a pass-through entity. Again, consult your CPA before choosing how you get paid.
- Partnership – The IRS regulation states you cannot be a Partner and an Employee. As a partner, your own equity in a company will be tracked, as will the equity of the other partners. Your Equity balance will be increased by capital contributions and business profits and reduced by Owner Draws and business losses. Profits and losses are shared equally among the partners.
*In specific situations, your CPA may recommend taking a Salary and an Owner’s Draw for tax planning purposes.
Now that we have reviewed Business Classifications and you have figured out if you are taking a Salary or an Owner’s Draw, let’s look at some other considerations.
What About Payroll Taxes?
We all pay into Social Security and Medicare no matter what type of payment we receive.
- Payroll taxes for salaried employees are deducted and matched by the employer.
- Unemployment and workers comp are opt-in in some states.
- Owner’s Draws contribute to Social Security and Medicare through the self-employed tax, calculated when you file your personal income taxes.
How to Pay Yourself an Owner’s Draw
As an owner, you can take a large or a small draw as needed. Draws are flexible and a useful tool when looking at cash flow. A draw is subject to income tax. Draws are not generally subject to payroll taxes. The company isn’t required to match payroll tax amounts in an Owner’s Draw.
A few things to consider when taking an Owner’s Draws:
- May not be on a steady schedule.
- A draw may hurt your retirement savings as these payments will not be salary deductions. Check with your CPA to see how draws will work with retirement.
- An Owner’s Draw can change your equity in the company. If you are in a Partnership, a change in equity will mean a change in ownership. Establishing a Partnership Agreement is an important step in understanding equity in your company as well as the responsibility partners have to each other and the company.
- You need to leave enough funds in the company to operate. Therefore, business owners need to be aware of reasonable compensation and consult with their CPA to set this up as part of an overall planning strategy.
- Be aware of tax liabilities. Work with your CPA to plan for your taxes accurately.
Self-Employed: All Alone at the Top
When we say you’re “Alone at the top,” it means in the final consideration, you are in charge. Employees, vendors, family, and many others depend on you to make good decisions and help the business thrive. When you set up your business, the best advice you can get is to consult your CPA when making the myriad decisions required. Learn as much as you can and seek expert advice and the experience of those that have been there before you. After you have done all of these things, trust your knowledge and intuition.