There are a lot of reasons to start a business, and making money as an owner typically tops that list. But should you actually draw a salary from your business?
I’m Neil Fridman with the Fridman Law Firm. Today, I want to walk you through your options to pay yourself as a business owner. Ultimately, the answer is yes, you should be paying yourself from your business. However, the question is whether this payment should come in the form of a salary or an owner’s draw. Let’s start by explaining the difference between the two.
A salary is something most of us are familiar with. This is where you determine a set wage for yourself and cut yourself a paycheck each pay period, as the owner of a business.
An owner’s draw
With an owner’s draw, on the other hand, a business owner takes funds out of the business for personal use. This can happen at regular intervals or on an as-needed basis. Many small business owners choose to use a draw to compensate themselves because it allows for greater flexibility, depending on how well the business is performing.
On the flip side, designating a set salary for yourself can put the business under stress during a down month. You should also keep in mind that the type of business entity you choose limits your options in terms of how to pay yourself.
The role of the entity
We have discussed entity types in previous posts. As you may know, the entity type you choose for your business affects multiple aspects of your company, and payment to yourself is one of those.
As an example, the IRS does not allow owners in a partnership to legally pay themselves a salary. They must use an owner’s draw, or they can institute what is known as a guaranteed payment for an owner that works regularly in the business.
Similarly, corporations must use a combination of salary and distributions or dividends, depending on whether or not the business is an S Corporation or C Corporation. Ultimately, the form of the ownership payment you choose must be legal, based on your entity type, and in line with the IRS’s rules and regulations.
Here is the key
There are additional factors to consider as well. No matter which type of payment method you choose, the business itself has to be able to bear the expense. Factors such as business performance and growth projections should come into play here, and many new business owners overestimate how much their company can afford to pay them.
This can eventually put the business into a financial bind and cause cash flow problems. You should also consider IRS guidelines for reasonable compensation based on what type of business you own, and make sure you’re taking enough money home each year to cover your personal expenses.
How to figure out the details
As I mentioned earlier, you should be getting paid from your business, but how much you choose to get paid and the method of the disbursement can be complicated. This is one of the areas where we help our clients on a daily basis at our firm.