Salary or Draw? How to Pay Yourself as Business Owner

Congratulations! Your small business has moved beyond the initial startup phase and is now a profitable venture. Although you may have worked for free in the early days, it’s time to pay yourself for your efforts.

You generally have two options for taking home a paycheck: a salary and/or a draw based on the structure of your business.

Your Payday

If you are an officer in a corporation, the law says you must be on the payroll and receive regular checks that include withholdings for Social Security, Medicare, federal income taxes, and state income taxes in states that require them.

If your company is legally structured as an S Corporation, you must receive regular paychecks with those same withholdings, but you also have the option of taking additional money beyond your salary in the form of a draw or distribution. Checks for draws and distributions are written without withholding the taxes that are taken out of a regular payroll check.

So, how do you decide how much to take as a salary and how much to take as a draw?

Reasonable Compensation

As far as your salary goes, the IRS requires you to earn reasonable compensation for the type of work that you’re doing. As a guideline, the government suggests choosing an amount similar to what another business would pay someone to do what you do.

Sheryl Schuff, a CPA who specializes in small-business bookkeeping and payroll, says that before you start cutting checks to yourself, you need to carefully consider the total amount of your salary and draws.

“Owners of S Corporations have come under increased scrutiny the past several years, as they typically prefer to take draws rather than payroll to avoid paying the associated payroll taxes,” Schuff says. “It’s imperative for business owners to understand the position the IRS takes on reasonable compensation. One of the largest financial risks to entrepreneurs is penalties and interest for incorrect payroll-tax reporting.”

Sole Proprietors and Partners

Sole proprietors and members of partnerships are free to pay themselves — or otherwise take the profits out of their businesses — whenever they’d like. Payroll withholdings do not apply, but each individual essentially pays the equivalent on his or her reported income at tax time.

For better financial organization, small-business owners who are sole proprietors or partners should consider paying themselves some kind of salary on a regular basis. A regularly scheduled payment from the business account to the owner helps to establish a clearer picture of what the company costs to run.

When paying yourself a draw, you must consider the eventual tax bill. You can implement a system as simple as keeping the cash to pay taxes in an envelope for later, writing monthly checks to the IRS, or making quarterly estimated tax payments.

It’s a big milestone when a business becomes profitable enough that you can be paid for your efforts. Deciding how much to pay yourself, and whether to take the money as a salary or as a draw, requires careful consideration.

About Carla Turchetti

Carla Turchetti is a veteran print and broadcast journalist with a passion for small businesses and the stories behind them. Her work currently appears on Infusionsoft's Big Ideas Blog and in the News & Observer, the regional daily newspaper in Raleigh, NC.
This entry was posted in Money, Taxes and tagged , , , , . Bookmark the permalink.
23 comments
AnjaliJoshi
AnjaliJoshi

hi,

This is a great article that is full of information. I have known a lot of friends who started their own businesses and it was always an awkward situation when payroll came around. All of them commented on how they didn't want to be overpaid, but how they were the owners. This information cleared a lot up. Recruitment Education

JR
JR

This may be a dumb question, but what impact does taking a draw instead of salary have on one's future social security retirement income benefits? - JR

Easy ABN
Easy ABN

My opinion is that ventures will almost always reap inconsistent earnings in their early phases. There's no doubt that maintaining the stability of a start up is difficult. In a year or two however, you should be able to get consistent earnings. To further ensure this scenario, always be sure to protect your company by registering your business number online. Avail of a business registration service provider to make it a hassle-free experience.

Book In Essence
Book In Essence

Nice article! My thought on this is there is really no right or wrong answer. There's absolutely no doubt the stability that comes with regularly scheduled "payroll" payments is a blessing. But then again, that stability can be very difficult to reach. Unless you can guarantee relatively consistent earnings (and expenses) for at least the next year or two, it probably won't make much sense to even think about taking consistent payments. If there is no guarantee, why not just take draws out? Again, I don't think there's a right or wrong answer. Making your living one way or the other really should not cause any financial distress. (Unless you're trying to minimize your income taxes; then it becomes a little more important). Just my $0.02.

KTD
KTD

I just bought a small online business on Jan 1, 2014 and made it an s-corp and spend only about 20hrs per week.  I am the sole owner and no other employees.  Based on current profit trend I can pay myself only may be $500 per month after loan payment.  I haven't taken any money, or reported anything to IRS or  State.  Do I need to pay myself a salary ? What if I don't make any money after loan payment?  If I make profit only on certain months, do I have to pay salary only on those months? 

ruthiejames95
ruthiejames95

This is a great article that is full of information. I have known a lot of friends who started their own businesses and it was always an awkward situation when payroll came around. All of them commented on how they didn't want to be overpaid, but how they were the owners. This information cleared a lot up!

Ruth James |  http://genzinksteel.com/platefabrication.html

bev56
bev56

I started a small business with 3 other people this year.  We are an S - Corporation.  None of us took salaries.  I am planning on doing a distribution of the profits this month.  

 

Do I do these via payroll with tax deductions, or as a draw?  As a S - Corporation, we want to reduce the profit shown on our P & L.  It was always my understanding that draws were balance sheet items, and would not hit the P & L.  Am I confused?  I've always been involved with C - Corporations, and am not fully clear on how to handle the year-end distributions.

bf
bf

Question.  I started a small with business with myself, and 3 others as owners.  We are an S -Corporation.  The company started in February.  None of us has taken a salary.  I am going to do a distribution of the profits this week.  Is this done via payroll with taxes taken out, or just a check from the company, and classify as a draw?  

 

As an S - Corporation, we want to reduce our profit showing on the P & L.  I was under the impression draws are balance sheet entries, and don't affect expense.  Am I confused?  

ericlng
ericlng

So do you pay any type of tax on a draw?  The pres/owner of our Scorp has been taking a regular paycheck, but I would like to have a year end bonus.  Is there anyway to payout a bonus without having to pay all the taxes like on a regular paycheck?

cturchetti
cturchetti

This is an updated version of this post that clarifies that sole proprietors and members of partnerships are free to take draws at any time, but that those payments will not have the withholdings taken out of them that a "payroll" check would have had, and that the tax liability comes later on the individual's 1040. Structuring a business so that a sole proprietor or member of a partnership receives a regular "salary"  is a tool to help a small business owner manage personal finances and gain insight into the cost of running the business by scheduling regular payments. It is not the same as a paycheck run through "payroll" for a corporation. Thanks Sheryl Schuff for your comment that the word "payroll' can be confusing.

Emanuel Stockton
Emanuel Stockton

Always invest in your business what you can and when you can. No matter what it is...

Skyler McLane
Skyler McLane

big business should try investing their capital back into their business via wages and benefit increases and hiring....

Sheryl Schuff CPA
Sheryl Schuff CPA

"As a sole proprietor, a partner in a partnership, or an officer of your own corporation, you should pay yourself a salary." Mark is correct that sole proprietors and partners in partnerships are never treated as employees who receive payroll subject to payroll taxes.  This is confusing to many small business owners who think of "payroll" as any money they take out of the business.  Officers of C corporations might be employees; it depends upon the specific situation. Owners of S corporations who actively participate in the business are always considered employees by the IRS. The whole subject of payroll is not as simple as it might sound.  Because the financial risks of getting it wrong can be substantial, it's generally a good idea to get help from a CPA and/or payroll professional.

 

Mark Smith RTRP
Mark Smith RTRP

This article is very misleading.

 

Firstly, sole proprietors and partners in a partnership are not paid salaries subject to withholding.  They take draws or in the case of partners, guaranteed payments. The draws are not taxed.  It is the profit that is taxed for sole proprietors and partners.

 

I suggest this article is rewritten as it is factually wrong and could cause sole proprietors and partners to incorrectly put their draws through payroll.

Alexis Sadler
Alexis Sadler

Pay urself!!! Investing in urself is investing in ur business!!!

Chris Pepper
Chris Pepper

It's probably not that hard of a question actually. Maybe it's a $.01 question.

jamigls
jamigls

@JR  You would pay SS & medicare from both a salary &/or a draw through your Self Employment tax (usually a quarterly pmt).  From another article....  “You may use money from the business for yourself, but know that the money you take out of the business will be subject to taxes at the individual tax filing level and subject to self-employment taxes,” says Lisa Schwartz, a CPA with Mitchell & Schwartz in Camarillo, Calif. In 2012 the self-employment tax rate is 13.3 percent for business owners on the first $110,100** of income and 2.9 percent on any income more than that amount.

For practical purposes, this means you’ll need to keep track of all your draws and set some of that money aside for taxes if your business is profitable. After your business gets established, you will pay self-employment tax in estimated quarterly payments to the IRS—something that can come as a shock if you’re used to being an employee and having taxes withheld from your paycheck.

2013-2014 employment tax rate is 15.3% on the first $117,000 for net self-income.  12.4 percent for social security and 2.9 percent for Medicare.  Hope this helps!

Sheryl Schuff CPA
Sheryl Schuff CPA

 @ericlng Generally, the word "bonus" refers to a payment related to services performed which results in it being taxable compensation, the same as regular wages and salaries are.A "draw" or "distribution" which is unrelated to services (and considered to be a return on investment) is not subject to payroll taxes.  The amount of the distribution flows through to the shareholder(s) on form K-1 (part of the corporate return) and gets reported as income on the individual's form 1040.  This may result in additional income taxes depending on the particular situation.

rwcpa
rwcpa

Mark is correct.  This article needs to be fixed.  

Trackbacks

  1. [...] or a mortgage, get insurance, and cover other expenses. Because it’s rare for any startup to generate income during its early phases, make sure you have enough money on hand to keep your head above [...]

  2. [...] and consider how much you want to be paid. Factor that into pricing your [...]