Salary VS Drawings: How to pay yourself as a business owner
Making money was probably at the top of your goal list when you decided to start your business. However, most business owners struggle with how to pay themselves a personal income due to fluctuating revenues, reinvesting money back into the business, and just not knowing how much is "fair" to take.
It's critical to strike a balance between obtaining adequate compensation and not depleting your business, whether you're a lone entrepreneur or a director in a private firm. Here's everything you need to know about paying yourself as a business owner.
Let’s look at a salary vs. draw, and how you can figure out which is the right choice for you and your business.
Owner’s draw or salary: How to pay yourself
Some business owners pay themselves a salary, while others compensate themselves with an owner’s draw. But how do you know which one (or both) is an option for your business? Follow these steps.
Step #1: Understand the difference between salary vs. draw
Before you can decide which method is best for you, you need to understand the basics.
Here’s a high-level look at the difference between a salary and an owner’s draw (or simply, drawings):
Owners Drawings: The business owner takes funds out of the business for personal use. Draws can happen at regular intervals, or when needed.
Business owner salary: The business owner determines a set wage or amount of money for themselves, and then cuts a paycheck for themselves every pay period.
Step #2: Understand how business classification impacts your decision
There are a lot of factors that will influence your choice between a salary, draw, or another payment method (like dividends), but your business classification is the biggest one.
The main types of business entities include:
· Sole Trader
· Limited Company
· Limited Liability Company
Why does this matter? Because different business structures have different rules for the business owner’s compensation. For example, if your business is a partnership, you can’t earn a salary because you can’t be both a partner and an employee.
Step #3: Understand how owner’s equity factors into your decision
“Owner’s equity” is a term you’ll hear frequently when considering whether to take a salary or a draw from your business. Accountants define equity as the remaining value invested into a business after all liabilities have been deducted.
When you contribute cash, equipment, and assets to your business, you’re given equity—another term for ownership—in your business entity, which means you’re able to take money out of the business each year.
It’s important to understand your equity, because if you choose to take a draw, your total draw can’t exceed your total owner’s equity.
Step #4: Understand tax and compliance implications
In addition to the different rules for how various business entities allow business owners to pay themselves, there are also various tax implications to consider.
Step #5: Determine how much to pay yourself
There’s a lot that goes into figuring out how to pay yourself. But here’s your next question: How much should you pay yourself?
There’s no one answer or formula that applies across the board.
You’ll need to take the following factors into account (more about this in the following blog post):
· Business structure
· Business performance
· Business growth
· Reasonable compensation
· Personal needs
Step #6: Choose salary vs. draw to pay yourself
Once you’ve considered all of the above factors, you’re ready to determine whether to pay yourself with a salary, draw, or a combination of both.
You’ll also have a better understanding of how much compensation you’re realistically able to take out of your business.