Your small business needs money in the bank to pay the bills and meet your goals for the future. And, as the owner, you want to bring home a good income, or at least enough to feed yourself and keep a roof over your head. Paying yourself can sometimes seem like a tug of war between your needs and the needs of the business.
To strike the right balance, it's important to look at the numbers, decide how much money your business needs, and understand the way your income will be taxed. Here's an overview to help you get started.
Finding the magic number
Start by looking at the numbers: How much revenue is coming in, how much is going out in expenses, and how much cash do you have? Don't just look at this month's data—go back and see how your business has done over time. Project the amount of revenue and expenses you expect in the months to come. Don't forget to include:
- Taxes. Consider all that may apply to you: not only your personal and business income taxes but also payroll taxes and unemployment taxes.
- Occasional or annual expenses. Even though they occur less frequently, it's important to include expenses like insurance premiums and equipment repairs.
- Expansion plans. If you plan to move to a larger location, launch a more complex website, or expand your product line, you may want to accumulate cash in the business for that purpose.
- Expected fluctuations. An ice cream stand is going to do better in the summer than in the winter, and a service business may receive a big lump sum at the start of a major contract and then nothing for months.
Use this information to figure out how much money the business needs in its accounts to stay afloat, with a comfortable cushion, in case your projections don't prove to be true. This will tell you what's available to pay the owners.
Ways to pay yourself
Business owners can pay themselves through a draw, a salary, or a combination method:
- A draw is a direct payment from the business to yourself.
- A salary goes through the payroll process and taxes are withheld.
- A combination method means you take part of your income as salary and part of it as a draw or distribution.
The method you use will depend on your business structure and tax situation.
Salary or draw: How to choose
To choose a payment method, look at the type of business entity you have, for tax purposes. For example, LLCs may be taxed as sole proprietorships, partnerships, or corporations. A corporation may be taxed as an S corporation or a C corporation.
If you are a sole proprietor or in a general partnership, you are not an employee of the business, you are the business. This means you will pay yourself a draw, and you will pay estimated taxes quarterly, including estimated state and federal income taxes and your self-employment taxes, which cover Social Security and Medicare.
If your business is a corporation and you work in the business, you are an employee of the business and you should pay yourself a salary, with taxes withheld. You do not have to take all your compensation as salary—you also can take a draw or distribution.
In an S corporation, all business profits flow through to the personal tax returns of the owners. An owner's salary is subject to payroll taxes, but distributions of profits are not. Some S corporation owners see a tax savings by limiting their salary and taking the rest of their pay as a distribution. However, the IRS requires the salary to be reasonable for someone in your position with your level of experience.
It can be hard to figure out how a salary or draw will affect your business or personal taxes. It will help to get advice from a tax professional.
You'll need to decide how often to pay yourself. Biweekly is a common choice, but you also can pay yourself more or less often. At a minimum, pay yourself quarterly to stay on top of your tax obligations.
For a draw, you can just write yourself a check or electronically transfer funds from your business account to your personal one. A salary is more complicated because you have to withhold payroll and income taxes. You can handle payroll processing yourself, but many business owners use a payroll service that calculates taxes, sends payments to taxing authorities, and generates pay stubs and W-2 forms.
Once you start paying yourself, stick to a consistent schedule. Reevaluate things throughout the year—and make changes if needed—to make sure you are meeting your business goals and obligations, as well as your personal ones.