Salary or Owner Draw: How Does Your Business Pay Its Owners?
Does it matter how your business pays its owners? In short, yes. To keep your business moving forward successfully, it’s important to make sure that your payment method is aligned with your business’s legal structure. Here, we provide a general overview on the differences between owner payment methods.
If you find that your business needs to change its payment method based on its legal structure, be sure to consultant your accountant and/or attorney to make sure it’s the right choice for your business.
Owner compensation: What are the key differences between a salary or a draw?
The COVID-19 pandemic and the subsequent launch of various funding relief programs highlighted the question of whether it’s best (or even required) to take owner compensation in the form of a salary or as an owner draw. The answers are largely determined by the IRS and are based on legal structures, and it’s important to know the basics:
- Owner draw/distribution: This is the method that’s typically used for sole proprietorships, simple partnerships and LLCs. In these structures, owners can also pay themselves through salaries. Per QuickBooks, “an owner’s draw (or simply a draw) refers to an owner taking funds out of the business for personal use. Many small business owners compensate themselves using a draw, rather than paying themselves a salary.”
In addition, “A draw of company profits is taxable as income on the owner’s personal tax return, and owners must pay estimated tax payments and self-employment taxes on draws.” The funds can be profits from the business, or repayment of funds that the owner loaned to the business from personal funds, or some combination of both.
- Owner salary: As with any jobs that pay salaries, business owners can establish an annual salary amount and pay themselves regularly (usually two times per month or biweekly). When owners are paid salaries, income taxes and other related taxes and deductions, including health insurance, disability or social security taxes, are deducted before the payment is received by the owner.
This is the method of owner payment that’s required for a common legal structure for small businesses, the Sub-Chapter S Corporation (commonly called an S-Corp). Owner salaries are also typically paid for C Corporation (C Corp) structures.
It’s important to know that when it comes to approving loans, most lenders are usually more concerned with the amount of compensation that business owners receive, rather than whether the owner pays it through salaries or draws. This is because the lenders want to know:
- how the amount taken impacts your business’s overall cash flow: Lenders want to see that there is a sufficient cash cushion to take advantage of growth opportunities or offer financial breathing room if challenges or unanticipated expenses arise.
- whether you’re taking sufficient payments to meet your overall debt obligations, personally and professionally.
How to determine if you’re correctly taking payment from your business
1. Review your business’s legal structure
Businesses often launch as sole proprietorships, LLCs and simple partnerships. And if your business is limited by its nature or by your choice (for example, if you launch your business as a “solopreneur” and always intend to keep it that way), then it’s possible that you may never need to change its structure.
Sometimes, though, as your business grows, it’s advisable to the legal structure. Some of the circumstances that may motivate (or require) you to change your business’s legal structure include that the business is:
- taking on new owners or outside investors
- applying for funding and a change in the legal structure will better position it for commercial loans
- ready to take advantage of specific tax advantages and legal protections that may not be available with the current legal structure
Clearly, you’ll want to talk to your accountant and business attorney for advisement so that you can make the best choice for your business.
2. If necessary and advisable, change the business’s legal structure
After reviewing your options with your legal and accounting team, making the appropriate changes to the structure is typically a fairly straightforward process, though it’s a process that takes some time and planning. Your attorney can often manage the process for your business.
3. Ensure that the owner/s payment method meets the new entity’s requirements
Owners’ pay is recorded both through bookkeeping and through tax filings, so it’s important to ensure that both areas are updated as needed. After your attorney has updated your business’s legal structure, meet with your accountant to ensure that your bookkeeping programs and tax filings also reflect the new structure and owner-payment methods.
Aligning your business structure and owner pay reflects well on your business
When your business’s structure and owner-compensation method align, it does more than please the IRS: It tells potential lenders that your business is managed more effectively, too.
If you’d like more information or are interested in funding to grow your business, contact us today. With access to more than 15 loan programs and a range of additional services, we’re committed to helping your small business get stronger today and thrive tomorrow.