Congratulations! Your small business has moved beyond the initial startup phase and is now a profitable venture. Although you may have worked for free in the early days, it’s time to pay yourself for your efforts. You generally have two options for taking home a paycheck: a salary and/or a draw based on the structure of your business.
If you are an officer in a corporation, the law says you must be on the payroll and receive regular checks that include withholdings for Social Security, Medicare, federal income taxes, and state income taxes in states that require them. If your company is legally structured as an S Corporation, you must receive regular paychecks with those same withholdings, but you also have the option of taking additional money beyond your salary in the form of a draw or distribution. Checks for draws and distributions are written without withholding the taxes that are taken out of a regular payroll check. So, how do you decide how much to take as a salary and how much to take as a draw?
As far as your salary goes, the IRS requires you to earn reasonable compensation for the type of work that you’re doing. As a guideline, the government suggests choosing an amount similar to what another business would pay someone to do what you do. Sheryl Schuff, a CPA who specializes in small-business bookkeeping and payroll, says that before you start cutting checks to yourself, you need to carefully consider the total amount of your salary and draws. “Owners of S Corporations have come under increased scrutiny the past several years, as they typically prefer to take draws rather than payroll to avoid paying the associated payroll taxes,” Schuff says. “It’s imperative for business owners to understand the position the IRS takes on reasonable compensation. One of the largest financial risks to entrepreneurs is penalties and interest for incorrect payroll-tax reporting.”
Sole Proprietors and Partners
Sole proprietors and members of partnerships are free to pay themselves — or otherwise take the profits out of their businesses — whenever they’d like. Payroll withholdings do not apply, but each individual essentially pays the equivalent on his or her reported income at tax time. For better financial organization, small-business owners who are sole proprietors or partners should consider paying themselves some kind of salary on a regular basis. A regularly scheduled payment from the business account to the owner helps to establish a clearer picture of what the company costs to run. When paying yourself a draw, you must consider the eventual tax bill. You can implement a system as simple as keeping the cash to pay taxes in an envelope for later, writing monthly checks to the IRS, or making quarterly estimated tax payments. It’s a big milestone when a business becomes profitable enough that you can be paid for your efforts. Deciding how much to pay yourself, and whether to take the money as a salary or as a draw, requires careful consideration.