Aug 26, 2024

Compensation for Business Owners: The Why, When and How

In general, business owners are allowed to compensate themselves either by taking a draw or by receiving a salary through their businesses. Read through to read some advice on how to properly compensate yourself as a business owner.

It’s not uncommon for business owners to fail to pay themselves. This usually happens as a result of business owners pouring as much of their cashflow as possible back into their businesses.

However, paying yourself can be beneficial, and understanding why receiving a salary as the owner of the business should be a priority will help you change the way you look at getting paid.

Salary and draw: Two main ways of getting paid

There are two main ways by which business owners can pay themselves through the earnings of their own business. Option No. 1 is through a salary, and option No. 2 is something known as a draw.

Salaries: the basics

With a salary, you’ll basically pay yourself as though you’re a W-2 employee. By withholding tax and paying yourself on predetermined dates every month — whether that’s biweekly or monthly — you will also receive a salary that is comparable to what others in your industry receive for a position similar to yours. This option is available to businesses that are classified as C corporations or S corporations.

Draws: special for owners

Also referred to as a distribution, a draw allows you to withdraw money from the pool of business-related proceeds as needed. However, you first have to contribute money of your own toward the business, and this money is recognized as your business-owner equity.

From there, you cannot withdraw more money from the business than the amount of money you have put into it, so there is a limit. This is an option available to business owners who operate a sole proprietorship, a partnership or an LLC, as well as to those who operate an S corporation. 

Once you decide that a draw is the path you’d like to take, you’ll need to figure out how much money you will take from the business. It’s recommended that you plan to start taking money to pay for your personal expenses only once your business has both (1) a sustained revenue stream and (2) a steady projected revenue stream.

Keep in mind, however, that the cash flow of the business must be the main focus. Never, ever take any amount of money from your business if it will jeopardize the success of your company.

Tax and compliance implications

Now, the differences between salaries and draws are important, but in addition to the rules concerning the options business owners have when it comes to paying themselves, there are tax implications that each type of business must consider.

Sole proprietorships

If you are the owner of a sole proprietorship, your only option is to take a draw. You can do so at any point in time, but you’re not allowed to withdraw more than your equity in the business as the owner. You’ll later pay taxes based on the profits of your business.

Partnerships

When it comes to compensating yourself as the owner of a partnership, you are required to draw. As a partner in the company, you can receive a payment for any services rendered to the partnership, which is viewed as a type of draw.

As the partner receiving the payment, you’ll pay taxes on the amount you were paid. Also, the payments sent to you as the partner will be subtracted from the partnership’s total profit value.

LLCs

LLC owners must pay themselves via the draw compensation method. Interestingly enough, LLCs can be taxed as either a sole proprietorship, a partnership or a corporation. Depending on the specific type of company your business is taxed as, make sure you follow the relevant tax laws.

S corporations

As an S corporation business owner, you are allowed to pay yourself via a salary as well as distributions, which operate as a draw. You — as the business owner — might be able to lower the amount of money that you owe in self-employment taxes if you accept business compensation via a draw.

C corporations

If you’re the owner of a C corporation, your option is to take a salary, though you are also able to receive a dividend. In other words, you’ll have the opportunity to receive a distribution of your company’s profits.

The value of this compensation — meaning your salary in addition to any dividends — will be taxed at the corporate level, but then the dividend portion alone will be taxed once more when the data is submitted to the IRS via the business owner’s personal tax return.

FICA taxes

Have you heard of FICA taxes? They are essentially self-employment taxes, which include Social Security and Medicare taxes. Now, all business owners have to pay their fair share of FICA taxes. 

With instances where you are paid via draws, your taxes won’t be collected when you are paid. Instead, business owners are required to put money aside — from the payments they receive — and the business owners will need to pay those taxes on their own.

On the other hand, for business owners who receive a salary, FICA taxes will be withheld via payroll, just as they are for every other employee. As a business owner, it is of utmost importance that you consult with a tax professional before you make any decisions or start taking compensation for yourself.

There are many nuances involved in the decision-making process, and you might not see them all from your perspective, since you are actively involved in your own business. For an unbiased view on what is best for your business, contact experts at your earliest convenience.

©2024