Paying yourself is necessary, but there’s no one-size-fits-all answer to how you should do so. Your business structure, goals, and cash flow will impact the best method.
Regardless of the different ways to pay yourself, it’s important to have consistent payments and accurate records to properly report your income at tax time.
Salary
A salary is one of the most important things a business owner can do for their financial health. A steady income can help prevent erratic spending and provide a solid foundation for savings that can be used for a rainy day or to make future investments in the company. It can also motivate entrepreneurs who need help maintaining their motivation to work hard as they try to grow their companies.
Determining the appropriate amount for a salary can be a tricky process, particularly for new business owners. It can depend on the IRS’ definition of a reasonable wage, personal expenses, and the individual business’s needs. To determine the best number, a business owner should begin by looking at their company’s net income and cash. After subtracting the business’s current debt and calculating any tax payments, they can begin to set a reasonable salary.
Once the business owner has determined a proper salary, they must consider how often it should be paid. The frequency can vary, but biweekly is a common choice. Regardless of the payment method, it is important to stay on top of payroll taxes by filing quarterly returns. A small business owner can handle the payroll process independently, or they can utilize a full-service solution that calculates and withholds taxes, sends payments to taxing authorities, and generates pay stubs and W-2 forms.
Owner’s Draw
Many factors determine how and when you will pay yourself as a business owner. Among these, your company’s legal structure is one of the most significant. It is essential to understand the ramifications of your choice.
Most notably, the type of compensation you receive will have tax implications. For example, if you are an independent contractor or member of a multi-member LLC, your options include taking an owner’s draw (non-reportable income) or receiving a salary. As a salary recipient, you will likely have federal, state, Social Security, and Medicare taxes withheld from your paycheck.
An owner’s draw allows a business owner to withdraw funds from the company for personal use. It is usually based on the equity you have invested in the company. The amount you take from the company will be recorded in your accounting system as a journal entry that debits the Owner’s Equity account and credits the Cash account.
As a small business owner, you should be careful to limit the amount of your draws so that there is enough money left over for ongoing business operations and other expenses. In addition, it is a good idea to reinvest some of your owner’s draw back into the company to help it grow and increase revenue.
Bonuses
As a small business owner, you need to strike the right balance between earning a living wage and making sure you’re left with enough money for emergencies, the company’s future growth, and paying your expenses. This can be not easy, especially during the early stages of your business. It is best to wait until you can afford a reasonable salary before taking funds from your business. Taking your profits out too quickly can put you in danger of running out of cash and may prevent you from funding any future growth, which could hurt the long-term success of your business.
Salary is one of the most traditional compensation methods for a small business owner, and it’s probably the method you’re most familiar with. It’s similar to paying an employee – you get a paycheck regularly, and the applicable taxes are automatically withheld from your payment. One advantage of this method is that it gives you more stability and is a hands-off way to handle your taxes.
Bonuses are a great way to show appreciation and generosity as a small business owner. You can give yourself a bonus for meeting a particular milestone or to reward yourself after a successful project. A bonus can also be used to thank your employees for their hard work and loyalty. Monetary bonuses are the most common, but nonmonetary programs such as days off or gift cards are also effective.
Other Income
As a business owner, you should always ensure that your income is enough to cover your living expenses, savings, and small luxuries. While it may not be the first thing you think of when launching your startup, learning how to pay yourself properly can help you avoid stress and set you up for success as your company grows.
Deciding on the best payment method for you and your business will depend on various factors, such as your business structure and growth stage. A good accountant can advise you on each option’s pros and cons based on your circumstances.
When choosing whether to take a salary or an owner’s draw, make sure to factor in your business expenses and any outstanding debt that you may have. In addition, it’s important to consider tax and reinvestment savings as you plan your compensation.
It’s also critical to set up a system for tracking payments and invoices, as this will make it easier to track how much you should be paying yourself each month. Using a money management tool can help you streamline this process and automate billing so you don’t have to spend time chasing down payments. This way, you can focus on building your business.
