As a business owner, there are two primary ways you can pay yourself from your business:
- Take a salary and your business gives you a W-2 at the end of the year.
- Take money whenever you want/need. This is called an “Owner’s Draw”.
Many business owners do a combination of both.
First though, you ARE taking money out of your business, yes? If not, now’s the time to start.
You put so much time, energy, love and expertise into your business, it needs to give you something beyond satisfaction back. Otherwise the relationship is one way — and that never works out long term.
The difference between taking a Salary vs an Owner’s Draw
SALARY: You pay taxes on your salary when the business pays you (just as if you had a job for someone else and received a paycheck). Your salary (and the business’ share of taxes for it) is deductible on the Profit & Loss Statement and reduces your Net Income (which reduces your current year taxes). You receive a W-2 at year end.
OWNER’S DRAW: This comes out of the Equity you have in your business and affects the Balance Sheet. Your business has already paid taxes on this money.
When taking an Owner Draw, it’s important to note that you’re taking cash out of the business that’s not reflected on your Profit & Loss. As a result, you may run a P&L which shows thousands of dollars in profit that’s no longer in the bank account.
Taking Owner Draws can create a cash flow challenge if you don’t track your numbers closely.
While many business owners consider taking an Owner’s Draw only, it’s a huge flag for the IRS and significantly increases your audit risk (ask your tax preparer about this).
It’s also a flag if you pay yourself less than the market wage and supplement it with a large owner’s draw. Market wage is simply what it would cost the business to hire someone who does what you do.
For example: Total compensation (W-2 salary + Owner’s Draw) of $150,000 made up of a $20,000 W-2 salary and $120,000 in Owner Draws is going to raise flags.
The same compensation made up of $100,000 salary and $50,000 in draws is a better percentage split and less likely to raise an IRS flag.
Knowing what the business can afford to pay you
As the business owner, you want to ensure you take a fair market wage, but what if the business can’t afford that (currently!)? You may need to take a smaller salary now while you build the business and then more later.
Planning for revenue and salary…
Know what you want your salary to be and unsure how much revenue you need to cover it and still make a profit?
OR… Know your desired revenue and wondering how much salary (yours and others if you have employees), your business can afford?
*Photo courtesy of Alexander Mills on Unsplash