If you’re just starting out as a business owner, you may consider how to pay yourself. Many owners ask, “Can I pay myself as an employee if I am a business owner? The answer is that you can pay yourself as a business owner, but it’s not always a “salary.” There are two main methods owners use to pay themselves. Considering which is better for your particular business structure is part of setting up shop. Let’s look at the difference between an Owner’s Draw vs a Salary.
What is the Difference Between an Owner’s Draw vs Salary?
When a business owner takes part of their personal equity out of the business to use for their own personal needs, they’ve taken out an owner’s draw. Generally, sole proprietors, partners, and LLC owner/members take owner draws as their payment. These draws can come on a schedule or be dependent on whether the business can handle losing more equity to the owner.
When a business owner pays themself a set wage from the business every pay period, they take out a salary. A salary is a regular event that pays out taxed, W-2 income to the owner.
Taking an Owner’s Draw as a Pass-Through Entity
LLCs, S-Corps, Partnerships, and Sole Proprietorships
If your business structure is any other than a C corporation, you may take an owner’s draw if you own equity in the business. The reason is that pass-through entities show profits on your personal taxes.
If you contributed assets to your business, you have equity invested there unless your business is going under and your liabilities outweigh your equity. If you own equity in your business, you can take money out of the business as the owner.
However, you need to understand your amount of equity as an owner or member before taking a draw. Your draw can’t exceed your current amount of equity.
For example, let’s say you own a small chemistry lab. You invest in the business at startup by contributing all of the tech you need to analyze samples along with the computers and online software programs. You spend $40,000 to outfit your lab.
Your business has plenty of clients and your overall income for the last year was $120,000. You pay your employees and business costs for the year. You then discuss how much equity you now own in the business with your attorney.
Your business is valued at a net worth of $200,000 using accounting formulas taking into account liabilities. Your own equity in the business is at $60,000. Therefore, you can afford to take an owner’s draw for $40,000 this year.
As the owner, you can choose to take a draw if your personal equity in the business is more than the business’s liabilities. However, anytime you take a draw, you reduce the value of your business by the amount you take out. With an owner’s draw, you decide how much to pay yourself, when, and why.
Accounting for an Owner’s Draw
According to Bench.co, “There are two “accounts” that are affected when you remove cash from your business: the Cash account and the Owner’s Equity account (these are both reflected on your balance sheet.) Cash is straightforward—the amount of cash in your bank is decreasing. Owner’s Equity is the total amount of money you as the business owner have invested or drawn from your business.”
When making a draw, it is common sense to leave enough equity in your business for it to continue operations. Also, consider how your draw will affect your taxes. You must still pay income and FICA taxes whether you take a draw or an employee salary.
For an LLC that did not take an S-election for federal tax purposes, using the draw method allows you to pay yourself as needed just as if you are a sole proprietorship or partnership.
As an LLC, sole proprietorship, or partnership, it makes sense to pay yourself with draws. You can still make your draws on a regular schedule as if they were a salary for planning purposes. However, there is no need to pay yourself a salary because your income is already part of your personal tax statements.
Why Take a Salary?
Non-profit, C corp, and S corp owners often choose to take a salary. While non-profit organizations have strict rules about salary approval and how much you can take, S corps and C corps do not.
LLC with S-election (S corp)
If your LLC takes the S-election for federal tax purposes, then you are considered an S corp and could use the salary method to pay yourself. You can also pay yourself reasonable non-taxable distributions in addition to your salary.
“However, a shareholder distribution is not meant to replace the owner’s draw. Instead, you must take a salary as a W-2 employee. A shareholder distribution is a non-taxable event, and if you try to replace your regular, taxed, W-2 income with non-taxable distributions, the IRS will catch you.” (1)
C Corporation (C Corp) Considerations
In general, as a C corp shareholder, you do not take a draw. Instead, you take a salary and any dividend distributions. You must pay taxes on any dividends you receive. The company’s money is not your money, so a draw would not be appropriate.
The C Corp files a tax return and pays taxes on its own profits. However, when those profits go to you as a shareholder, you also pay taxes on those dividends you receive. This is called “double taxation.”
Suppose your corporation chooses to conduct business without any employee salaries. In that case, the IRS classifies any corporate payments as salary, even if the owners intended the monies as distributions. (1)
Many legal factors go into choosing whether to take an owner’s draw or a salary. However, the type of income you make from your company is highly dependent on your business tax structure.
We Can Help
If you need help choosing the best business structure for your startup, get in touch with us at Hopler, Wilms, and Hanna. We help you make sense of how to pay yourself, with an owner’s draw or a salary. We stay on top of the legal landscape in North Carolina so that you don’t have to. We understand business formation legalities in addition to taxation and concerns in your industry. Our focus is business law and we bring our expertise to everything we do for you. Whether you just have questions or need an entire business plan from the bottom up, we have the answers you need to help your business thrive. Contact us today and find out how we can help you.