What are the options to pay yourself as a business owner?
Making money and earning a living from your business is great. After all, that’s probably one of the main reasons for setting it up in the first place.
But as a small business owner, how do you go about actually paying yourself? And what are the things that you need to consider when looking at how much to pay?
There are several ways of paying yourself as a business owner, and how the business is structured will affect how you are able to take money out of the business. It will also impact on how you are taxed on this amount, so there is quite a bit to consider when deciding on the best course of action.
Importantly, it’s also vital to then consider just how much is appropriate to take out of the business, based on what your personal budgetary requirements are and taking into consideration the cash needs of the business in the short to longer term.
Paying yourself as a sole proprietor
As a sole proprietor, you are the owner of the unincorporated business. You are effectively self-employed and not an employee.
In these circumstances, all of the profit that is earned in the business is yours, and you are able to take this amount from the business as ‘business drawings’. This amount is then subject to personal income tax.
This structure is by far the easiest and most straightforward set up for a business, as there is minimum regulation involved in registration and ongoing, and the arrangements for set up are quick and easy.
The business structure is most suited to a business that has low risk and low earnings. Quite often, this is the first stage for a new business that is setting up from scratch.
It allows you as the business owner to operate the business as you want and to be rewarded by the profits generated from your activities.
In the first few years of operation, this structure would suit your level of activity and keep things simple in terms of how your company finances are organized.
This may be fine for the first few years, or even forever for some small business owners who are looking to earn a living from a relatively small, low risk operation.
In time, however, it may be that your business has grown, or your plans have evolved into generating more revenues and expanding your offering.
That may be a time that triggers a review of your business structure and to consider other set ups that may have become more suited to your expanding business.
Paying yourself in a partnership
Like the sole proprietor set up, paying yourself in a partnership means that the profits are distributed to the partners via what is termed as ‘partnership drawings’.
Each partner is then taxed on their partnership drawings and liable to personal income tax on these amounts.
Again, as a partner, you do not receive a salary from the business, as you are effectively self-employed and not an employee of the business.
Paying yourself from a Limited Liability Company (LLC)
This is a business entity that also allows you to pay yourself through an ‘owner’s draw’. It’s a structure that is a bit more complicated than the sole proprietor set up, but also gives you other options for paying yourself that can vary between electing to be treated as either a sole proprietor, partnership, or corporation.
It essentially allows you to be paid from the LLC via different options depending on how many people are involved in the business.
This may be helpful if the business is growing or evolving, with more people becoming involved in the business.
If it’s just you, then you’ll be treated as a sole proprietor.
If there are others involved, then you can elect to be treated as a partnership or a corporation from a tax point of view.
As a single-member LLC, the company’s profits and your own income are the same. If you decide to take everything out each year, your draw is the total profit for the year.
If you want to keep a bit back in the business, perhaps to upgrade a computer system or buy new shop fittings, you can draw out an amount that leaves some of the profit in the business bank account to pay for the upgrade or new fittings.
In this example, the personal income tax is calculated on the total profits for the year, regardless of whether the full amount was taken out through drawings.
Paying yourself from a corporation
In this structure, with an incorporated business, it is possible to pay yourself with a salary and to receive money from the business as a ‘dividend’ payment.
A dividend is another way of distributing profits from an incorporated business, that allows a payment (a ‘dividend’) to be made to each of the shareholders.
In this set up, it may be that you are the only shareholder in the business.
Alternatively, you may have other shareholders if you have people who are working with you and appointed as directors, and this allows the profits to be distributed to all shareholders.
To receive a salary, you need to set yourself up as an employee of the company. This will allow you to be paid a regular salary, most likely monthly, that is treated as a business expense of the business, and you will then pay personal income tax on the monthly salary payment.
Both S-corporations, C-corporations, and a limited liability company that is taxed as a corporation is required by the Internal Revenue Service (IRS) to pay a reasonable salary (or reasonable compensation), which means your salary should be comparable with what someone else doing the same job in your industry would be paid.
The amount of dividend that can be paid is dependent on the profits that the business has made during the year.
The profit that can be distributed (or paid) to all shareholders is calculated by taking all revenues and deducting expenses and corporation tax. The expenses will include any salary that you may have paid yourself during the year.
In this structure, it is common for the business owner, or director as they will be called in a corporate entity, to be paid both a salary and a dividend payment.
The benefit of receiving a dividend payment is that no payroll taxes or self-employment taxes (which include social security and Medicare) are paid on this income.
Owner’s draw – pros and cons
The upside of taking out an owner’s draw is that is simple and straightforward, with little administration and easy to record and control.
The profits that the business generates can be immediately transferred to you, and this amount is then subject to personal income tax.
There is no need to set up employee records and it keeps costs minimal.
It’s also important to highlight that you are directly rewarded for the company’s success. More hard work and profits means that you can take out more money from the business.
A downside is that you, as the business owner, are also fully liable for the business. Unlimited liability goes straight from the business to you, and there is nothing to separate between the business and you as an individual in terms of any debts that are payable.
Salary – pros and cons
Paying yourself through a salary gives you more certainty about your income. If the business performs badly for a few months and generates smaller profits, or even a loss, you are still able to take out a set amount by way of wages each month, and able to meet your household bills.
If all you are doing is receiving a paycheck, with no additional dividend payments from profits, you will also build up some cash in the business to expand. This may mean your business will grow faster than if you were taking out all the profits that the business is generating.
How much to pay?
The answer to this question will vary between business owners and depends on various things such as personal budgets and your future ideas and plans for the business.
As an individual, you will have bills to pay and personal desires to spend money on things each month. That figure will determine and guide what amount you want to receive from the business, by whatever means, each month.
If earning a living from your business is the goal, with no plans to grow the business, then this will help determine how much to take out and also help guide whether a draw is simpler and more straightforward in this circumstance.
If, however, you plan to grow the business and to invest in capital items that will help the business to grow even more, then you will need to keep some of the profits in the business bank account.
In this scenario, you should not take out all the profits generated, but leave some in the business and take out what you need for living and personal expenditure.
What Is The Best Way To Pay Yourself As A Business Owner?
In the early years, a simple set up and taking out money by way of an owner’s draw is probably most appropriate.
Things may well remain like this if you are happy with this arrangement.
However, if you become even more entrepreneurial and want to grow, it may be that you change the business structure from a sole proprietorship to an LLC or a corporation.
This will then allow you to take a salary and to top this up through taking out profits by way of a dividend.
There is a lot to consider when looking at how to pay yourself from your business and, importantly, it’s a decision that needs to be reviewed on a regular basis as both your circumstances and business change.
The simpler sole proprietorship structure is most likely the best option in the early days, but this may need to change as your business changes or grows.