Launching a new business involves making countless decisions, one of which is deciding how to pay yourself.
Especially in the early stages of building a brand, it can be stressful to decide the best way to balance your personal finances with the business's needs. Giving yourself a salary is a safe choice, but you could also opt for an owner's draw.
Owner's draw gives you more flexibility over when and how much money you take from your company. It does, however, come with specific payroll considerations. This guide will walk you through everything you need to know about owner's draws so you can choose the best compensation scheme for your business.
How And When Owners Can Take Draws
Choosing how to pay yourself is one of the most important decisions you can make as a small business owner. If you're running a sole proprietorship or you're in a partnership agreement, you might lean towards an owner's draw. This means you're pulling money from your business's earnings as you need.
An owner's draw is a flexible way to manage your personal income, especially when your business's cash flow is still unstable. You can withdraw as much and as often as you'd like as long as there's cash in your business accounts. However, unlike a regular employee payroll, an owner's draw doesn't immediately account for personal tax returns, Social Security, or income taxes. You will need to account for this separately to remain tax-compliant.
On the flip side, paying yourself a salary might make more sense if your startup is structured as an LLC or a corporation. This route makes your income consistent, and just like any other employee payroll, taxes are taken out upfront. The payroll method can provide a clearer picture of your overall business and personal expenses, making your life easier during tax season.
If you're not sure if an owner's draw is possible for you, then consulting a guide on how to choose a payroll management system can direct you towards what's best for your business model.
Payroll Implications For Business Owners
As a business owner, mastering payroll means grasping the differences between drawing a salary and taking an owner's draw. This choice impacts how you're paid and carries significant implications for your business's operational flow and tax duties.
Differences Between Salary And Owner's Draw
The choice between a salary and an owner's draw depends on the type of business structure you have.
A salary is a regular payment, similar to what you'd give an employee. It's typical for owners of corporations or limited liability companies (LLCs) that choose to be taxed as corporations. It shows up as a guaranteed payment on the balance sheet, offering a clear picture of the business's financial obligations.
An owner's draw, however, is more common in sole proprietorships, partnerships, and LLCs taxed as such. This method allows business owners to withdraw earnings directly from the business's profits, affecting the owner's equity displayed on the balance sheet.
Tax Implications Of Paying Yourself A Salary Vs Taking A Draw
Choosing between a salary and a draw also comes with different tax implications.
Paying yourself a salary means that you are considered an employee of your company. As both owner and employee, you'll have to deal with both ends of the payroll tax system up front. This can simplify personal tax filings since payroll startup software automatically calculates and withholds the necessary taxes, including Social Security and Medicare.
Taking an owner's draw is less work at first, but requires careful personal tax planning. Money taken as a draw is not subject to payroll taxes at the time of withdrawal. Instead, you'll need to make quarterly estimated tax payments to cover your income taxes and self-employment taxes.
Understanding these distinctions and their implications is crucial for effective startup payroll management. Startup payroll software can help manage these processes, ensure compliance, and optimize your financial strategy, whether you opt for a salary or a draw.
Legal Structures And Their Impact On Owner's Compensation
Choosing between an owner's draw vs salary depends heavily on your business type and its financial stability. From sole proprietorships to LLCs, each structure has its own rules and implications for owner's compensation.
Sole Proprietorship
In a sole proprietorship, the business and the owner are legally the same. This means any income earned is directly tied to the owner. Owners typically take an owner's draw, withdrawing funds from the business for personal use.
These draws directly affect the owner's equity shown on the balance sheet, but there's no formal payroll startup process since the owner isn't an employee of the business.
Partnership
Partnerships operate similarly to sole proprietorships, with multiple owners sharing the profits. Each partner takes an owner's draw according to the partnership agreement, affecting their respective owner's draw account. Like sole proprietorships, these draws impact the owner's equity but bypass traditional payroll processes.
Limited Liability Company (LLC)
An LLC offers more flexibility. Owners can choose to take a draw or be treated as employees and receive a salary.
Taking an LLC owner's draw decreases the owner's equity, while receiving a salary introduces payroll considerations, including withholding taxes. The LLC structure also affects personal liability and tax obligations, adding another layer to consider when deciding on compensation.
S Corps
In S Corps, owners can receive money through owner's draws and salaries. However, the IRS requires that owners working in the business also receive a reasonable salary before taking any draws. This salary is subject to payroll taxes, while the draws are not.
S Corp shareholders report their share of the profit and loss on personal tax returns, blending the benefits of pass-through taxation with the ability to take draws, reflecting their dual role as employees and owners.
C Corps
C Corps and their owners are considered separate legal entities, which means owners can't take draws. Instead, shareholder-owners must receive compensation through salaries, and any additional profit distributions are given as dividends. Salaries are deductible business expenses for the corporation but are subject to payroll taxes.
Dividends, while reflecting profit distribution similar to draws, are taxed at the shareholder's personal tax rate without payroll tax obligations. This separation reinforces the C Corp's distinct entity status, impacting how owners extract value from their business involvement.
Not-For-Profits
Not-for-profit organizations operate differently from for-profit businesses, especially regarding financial distributions like owner's draws. In not-for-profits, there are no owners in the traditional sense, meaning profits aren't distributed to individuals for personal gain. Instead, any surplus revenue is reinvested into the organization to support its mission and objectives.
This fundamental difference emphasizes the not-for-profit model, where the focus is on serving a public or community interest rather than generating profit for owners or shareholders. That means you're not allowed to do an owner's draw from a non-profit, but you may receive a salary in exchange for the work that you do for the organization.
How To Calculate And Record Owner's Draws
Accurately calculating your owner's draws is crucial for keeping your financial records straight and making tax time less stressful. Starting with a clear system ensures you'll smoothly navigate tax season, with a transparent view of the income you've drawn from your business.
Here's what to consider when planning and recording your draws.
Factors To Consider When Calculating Owner's Draws
Before you decide to take money out of your business, you should consider several factors to ensure the financial health of your company. While it might be tempting to just head to the ATM and withdraw some cash, each draw should be part of a broader financial strategy.
Here's what you need to consider:
Business Profit
If your business isn't profitable, you won't be able to comfortably withdraw money without jeopardizing normal business operations. That's why some business owners choose to withdraw profits only after all expenses have been paid.
This will reduce the impact of your draws on business operations and incentivize you to find ways to increase your profit margins. Consistently reviewing profit margins will guide you in making informed decisions about the timing and amount of your draws.
Fixed Amount
Some business owners opt for a fixed draw amount, similar to a regular salary. This method offers predictability for personal financial planning but requires a balanced approach to ensure the draw amount aligns with the business's fluctuating profits and cash flow needs.
To determine a fixed amount, you must forecast future earnings and expenses to establish a sustainable withdrawal rate that won't endanger the business's financial stability.
Ownership Share
In businesses with multiple owners, the proportion of ownership significantly influences the size of each owner's draw. The allocation should reflect each owner's share, typically outlined in the business's founding documents or partnership agreements.
Transparent communication and agreement among partners are vital to setting equitable draw amounts, respecting each owner's stake in the business while ensuring its financial needs are met.
Business Needs
Forecasting both the immediate and future financial needs of your business is critical. Before deciding on a draw, consider all upcoming expenses, whether they're for capital investments, scaling operations, or other financial obligations, to keep your business on solid footing.
Balancing personal financial needs with the business's sustainability ensures that owner's draws don't hinder the business's ability to fund its operational needs and growth initiatives.
Steps To Record The Draw
Just as vital as figuring out your owner's draws is making sure they're properly recorded.
Here's a primer on how to document these transactions, step by step. It covers picking an accounting style, setting up a dedicated owner's draw account, recording each transaction, and keeping tabs on when and how much you're drawing.
Choose An Accounting Method
The first step in recording the owner's draw is selecting an appropriate accounting method. Whether you choose cash-basis or accrual accounting will impact how and when transactions, including owner's draws, are recorded.
This choice affects your business's financial reporting and tax obligations, so it should align with your overall accounting practices and comply with legal and tax requirements.
Create An “Owner's Draw” Account
Making a dedicated “Owner's Draw” account within your accounting system is crucial for tracking these transactions separately from other business expenses. This equity account represents the owner's withdrawals from the business, distinguishing personal draws from operational expenses.
Record The Transaction
Every draw transaction must be carefully recorded, detailing the withdrawal's impact on the business's finances. These entries should decrease the equity account, reflecting the owner's reduction of investment in the business for personal use.
Maintaining precise records in the “Owner's Draw” account is important for keeping clear financial statements. It helps separate the owner's withdrawals on the balance sheet from other equity transactions, ensuring financial clarity.
Track The Date And Amount
When recording owner's draws, be sure to make note of the withdrawal date and amount. Being able to identify how often and how much money is taken out via owner's draws can help you plan for future expenses and stay compliant with tax laws.
Tracking these details also helps with analyzing the owner's draw vs owner's equity dynamics over time. Detailed tracking offers insights into how personal withdrawals affect the overall equity structure of the business. For startups, using startup payroll software can simplify payroll for startups by managing payroll tax management and ensuring you're keeping up with reasonable compensation standards.
Balance Owner's Compensation With Business Health
As a business owner, one of the many decisions you will have to make involves how much money you withdraw from the company. Take too much, and you'll jeopardize the company's finances. Take too little, and your personal finances will suffer.
Judging your business's financial strength is key to choosing between taking an owner's draw or a salary. After settling on one, you can take the next steps toward establishing your payroll practices and staying on track with tax requirements.
Our recommendation? Have a finance professional help you with these decisions. Take control of your business's financial future today.
your business in our interactive demo!
.png)
