You love your business, but that doesn’t mean you can afford to work for free. Yet, figuring out how to pay yourself as a business owner can be complicated.

You need to think carefully about how you take money out of your business entity. Typically, that’s done one of two ways: a salary or an owner’s draw.

An owner’s 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.

Patty could withdraw profits generated by her business or take out funds that she previously contributed to her company. She may also take out a combination of profits and capital she previously contributed.

Because Patty is a sole proprietor, all of the income earned by her business will show up on her personal tax return and she’ll need to pay estimated tax payments and self-employment taxes on those earnings.

She doesn’t pay separate taxes on the owner’s draw because she’s simply taking out money that has been taxed in the past (which reduces equity) or money that will be taxed in the current year.

Pro:

• Greater flexibility: Rather than needing to pay herself a set amount, Patty’s compensation can fluctuate depending on how her business is performing.

Con:

• Reduced funds: An owner’s draw reduces a business’s equity, which reduces the funds available for future business spending.

You probably already understand what a salary is: You get paid a set amount every pay period. It works really similarly when you’re the business owner. You determine your reasonable compensation and give yourself a paycheck every pay period.

For example, maybe instead of being a sole proprietor, Patty setup Riverside Catering as an S Corp. She has decided to give herself a salary of $50,000 out of her catering business. From there, she could do the math to determine what her paycheck should be given her current pay schedule.

Pro:

• Less admin work: Taxes are deducted from your paycheck automatically. Additionally, your compensation as the business owner is a more stable expense, which makes it easier to track your income and expenses.

Con:

• Cash flow: What happens if your business has a down month? While it’s possible to adjust your salary to give yourself some more wiggle room, your salary still needs to fall within the IRS’ definition of reasonable compensation. Plus, figuring out how much to pay yourself can be challenging.

Before you make the owner’s draw vs. salary decision, you need to form your business.

There are many ways to structure your company, and the best way to understand the differences is to consider C Corps vs. all other business structures:

• Corporations: The C Corp files a tax return and pays taxes on net income (profit). The owners can retain the after-tax earnings for use in the business, or pay shareholders a cash dividend. If a dividend is paid, the dividend income is added to other sources of income on the shareholder’s personal tax return.
• Pass-through entities: Generally, all other business structures pass the company profits and losses directly to the owners. Sole proprietorships, partnerships, S Corps, and several other businesses are referred to as pass-through entities. Assume, for example, that Patty’s catering business is a partnership and her share of the income is $10,000. The partnership would file a tax return and issue her a Schedule K-1, which reports the $10,000 in income. The $10,000 is then reported on her personal tax return as income from her partnership. The partnership tax return documents the partners, the percentages of ownership, and the partnership’s profit—but no taxes are actually calculated on the partnership tax return.

There are some exceptions, but generally a business faces double taxation as a C Corp. If not, the company is a pass-through entity.

You have a lot of love for your business, but you also know that love doesn’t pay your bills. As the business owner, you need to pay yourself to cover your personal expenses and justify the time you spend working in your business.

But, of course, compensating yourself isn’t always straightforward. Be sure to consult with your CPA about which is the best method for you and your business.

*This content is for information purposes only and should not be considered legal, accounting or tax advice, or a substitute for obtaining such advice specific to your business. Please consult a tax professional for information on your individual business situation

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Article Source: https://quickbooks.intuit.com/r/payroll/salary-or-draw-how-to-pay-yourself-as-business-owner/