Step #1: Understand the difference between draw vs. salary
Before deciding which method is best for you, you must first understand the basics. As a refresher, here’s a high-level look at the difference between a salary and an owner’s draw (or simply a draw):
- Owner’s draw: The business owner takes funds out of the business for personal use. Draws can happen at regular intervals or when needed.
- 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
Many 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:
- C Corporation (C Corp)
- S Corporation (S Corp)
- Sole Proprietorship
- Limited Liability Company (LLC)
- Partnership
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 the IRS says 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 deducting all liabilities. You can calculate your owner’s equity using the following formula:
- Assets - liabilities = Owner’s equity
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.
Understanding your equity is important 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 several tax implications to consider.
Concerning taxes, C Corps are different from other business entities. Here’s how:
- C Corporations: C Corps are subject to double taxation. The C Corp files a tax return and pays taxes on net income (profit).
- Pass-through entities: Generally, all other business structures pass the company profits and losses directly to the owners. That’s why they’re referred to as pass-through entities.
Another consideration is Social Security and Medicare taxes. Social Security and Medicare taxes (known together as FICA taxes) are collected from salaries and draws.
Both sole proprietorships and partnerships require paying self-employment taxes on company-earned profits. The self-employment tax collects Social Security and Medicare contributions from these business owners. If, instead, a salary is paid, the owner receives a W-2 and pays Social Security and Medicare taxes through payroll withholdings.
In contrast, S Corp shareholders do not pay self-employment taxes on distributions to owners, but each owner who works as an employee must be paid a reasonable salary before profits are paid.
Step #5: Determine how much to pay yourself
A lot goes into figuring out how to pay yourself. But here’s your next question: How much should you pay yourself?
There’s not one answer or formula that applies across the board. You’ll need to take the following factors into account:
- Business structure
- Business performance
- Business growth
- Reasonable compensation
- Personal needs
It’s possible to take a very large draw as the business owner. You may pay taxes on your share of company earnings and then take a larger draw than the current year’s earning share. In fact, you can even take a draw of all contributions and earnings from prior years.
However, that isn’t without its risks. If you take too large of a draw, your business may not have sufficient capital to operate going forward.
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.
