How to pay yourself as a business owner depends on the business structure, the stage of growth of your business, and other factors.
There are two main ways to pay yourself as a business owner:
Salary: You pay yourself a regular salary, withholding taxes from your paycheck. This is legally required for businesses that are structured as S- or C-corporations or a limited liability company (LLC) taxed as a corporation. The IRS has a “reasonable” compensation requirement, which means your salary should be comparable with what someone else doing the same job in your industry would be paid.
Owner’s draw: Outside of running W2 payroll, if you are a sole-proprietor, S-Corp or Partnership, all remaining money in your business account can be distributed to the owners, equally per their ownership percentage, at any time. You are taxed on all of your profits annually, so all the remaining cash in your business account is yours to choose what you do with. Just remember you will owe federal tax on your profits when filing your personal 1040 taxes.
How to decide?
Your specific business structure dictates whether you can take a salary and/or an owner’s draw.
How much should you pay yourself?
Great question! We get this one all the time. Most people just guess an amount, which usually causes them to over-pay unnecessary payroll taxes, which is a waste of money. Your reasonable salary should be based on your business’s net profit, which is your business revenue minus all business expenses, and/or using our third-party software to answer a number of questions to determine what your maximum salary amount should be. What you want to avoid is risking an IRS audit because you did not pay yourself a high enough W2 salary, or have any justification with how you came up with your W2 salary amount.
Avoid These Mistakes
- Mixing personal and business finances
- Not budgeting for taxes
- Not paying yourself enough W2 salary and risking an IRS audit, per IRS rules on S-Corporation reasonable salary.
Ideally, your compensation should be part of your business plan. Your financial projections should include the amount of your salary or owner’s draw to help you understand what your business needs to grow. If you need help determining which method works best for your situation, give us a call.