Whether you run a small business or thinking of starting one, knowing how to pay yourself as a business owner is key. And deciding on how to pay yourself depends on many factors, such as your business’s net profits, corporate structure, and financing. You’ll also need an overview of Federal requirements from the Internal Revenue Service (IRS) and potentially other agencies, in addition to meeting state requirements. Failure to comply with government rules and regulations can lead to fines and penalties.
Considering how to pay yourself as a business owner can be complex. But using the best method for you — and your business — can help you succeed as a small business owner.
Keep reading for an overview of all the factors you’ll want to consider, helping you make the best choice! Your paycheck matters, especially as a small business owner.
Thinking of becoming a small business owner but don’t know where to start? Here are 10 Steps to Starting a Business!
How Much Should You Pay Yourself?
First things first — how much should you be paying yourself as a business owner?
Like one of the most famous Greek mythology figures, Icarus, you’ll want to avoid extremes of too low or too high. If you fly too high, you risk getting burned. And if you fly too low? You could get crushed by the waves. In other words, paying yourself a fair amount can help keep your business soaring.
When you start a fledgling business, you may be tempted not to pay yourself initially. This can be particularly true if your business isn’t turning a profit or not as much as you hoped. But this choice isn’t without consequences.
For one, you could limit your potential business financing options. Lenders often look unfavorably at your lack of income from the business. Why? It could imply a lack of profitability and viability — all crucial factors in repaying debt. That means applying for business loans or other funding can be more challenging. Lenders are unlikely to risk approving a loan if your ability to make payments seems iffy.
There are also factors to consider if paying yourself too much, defined as one significantly above the norm for your title, company size, and industry. First, you don’t want to strain your business’s profits and long-term viability. Without a profit, your business can’t last. You’ll also want to pay attention to your business’s short- and long-term operating needs —and ensure your cash reserves can fund ongoing needs.
Second, both lenders and government regulators can be skeptical if you pay yourself too much. An above-the-norm pay scale can indicate a lack of long-term profit viability or business planning. And the government? In many situations, the government requires a “reasonable” payment to yourself. “Reasonable” is generally defined as being in line with the norm for your title, duties, business size, and industry.
Whatever income level you choose, be careful — and don’t mix personal and business expenses or accounts throughout your business’s lifetime. You’ll want to track your personal and business accounts separately so that you can make the best income decisions!
It’s wise to work with accountants and financial advisors on the amount you pay yourself to avoid issues and establish a reasonable, regular income. Most small business owners struggle to pay themselves with regularity.
Methods of Paying Yourself
There are two general methods of paying yourself in a small business: Salary or draw.
A salary is a fixed amount paid at fixed intervals (biweekly, weekly or monthly). A salary requires filing a W-4 form to receive a paycheck in the first place and a W-2 form for income tax. All taxes and required government withholding, such as unemployment insurance and Social Security, are automatically done in each paycheck. The appropriate forms for all required withholding, both state and Federal, will need to be filed through payroll.
A draw is a specific amount withdrawn from company profits. Draws may be done at set intervals, but it’s up to you! Similarly, the amount can either be fixed at a certain amount, a certain percentage of profits, or set up as a variable.
You can draw a salary if your business structure is a C Corporation, an S Corporation, or a Limited Liability Company (LLC) taxed as a corporation. You can choose a draw if your business is a sole proprietorship, a partnership, or an LLC not taxed as a corporation. You can also take a draw if your corporate structure is a C Corp, but it’s a good idea to check with an accountant and financial advisor first!
Should your business structure be a C Corp, S Corp, or LLC? Learn more about these business entities in What’s a Business Entity?
Pros and Cons of a Salary
What are the advantages of a salary? A salary is fixed and consistent. In terms of your own income, you’ll always know how much income you’ll receive and when. Receiving a salary also eliminates any guesswork or ongoing effort in paying taxes and other required withholding. Once you set up a reasonable salary amount and your payroll system, you’re all set!
A salary can also streamline your payment of taxes. You’ll pay annually and don’t have to pay or calculate quarterly estimated personal taxes or self-employment tax. And if you need funding in the future, lenders consider salaries a stable form of income — as long as the salary you choose is reasonable.
Plus, a salary allows you to participate in a 401(k) plan since the IRS mandates that 401(k) plan contributions can take place only through a salary.
The biggest drawback of choosing a salary is the lack of flexibility. It’s common for new small businesses to make uneven profits per month (or even per week). Even seasoned small businesses may have varying profits. Since a salary is a fixed amount, you’ll want to ensure that your paycheck can always be covered by your profits. Otherwise, you could face overdrawn accounts.
Pros and Cons of a Draw
The main advantage of a draw is flexibility. If your company has uneven profits, you can choose to track whatever the profits are with your draw. Draws can help avoid risks associated with fluctuating business operating income. But draws also have several potential disadvantages.
You’ll need to be careful when tracking your profits with a draw. If you aren’t, your draws could drain your accounts. Draws can lack consistency and predictability — for both your daily income and your business as a result.
If you’re taking a draw, you or your accountant must calculate and pay quarterly estimated and other taxes. You must also ensure that you file the required forms, such as a Schedule K-1 if you have an S Corporation. Otherwise, you’ll face fines and penalties. That’s why draws can take more of your (or an accountant’s) time than a salary. Tracking your profits and doing your taxes may be more time-intensive.
A draw can also cause some issues with financing options. Some lenders may be OK with a steady draw. But others may think it poses more risk to potential loan payback, especially if the amounts are unpredictable.
Managing your payroll as a small business owner can be challenging, but it doesn’t have to be! Here’s how to Streamline Your Business and Save Time.
How to Pay Yourself as a Business Owner Using ROBS
Rollovers for Business Startups (ROBS), also known as 401(k) business financing, lets prospective or current business owners access their retirement savings to fund a business — without withdrawal penalties. ROBS isn’t a loan. And that’s why it’s rising in popularity among business owners looking to start or fund their business debt-free. But how do you pay yourself as a business owner using ROBS?
You’ll need to be particularly mindful of government rules and requirements when it comes to payroll. First, be aware that your retirement funds cannot be withdrawn for either a salary or a draw. ROBS transactions must take place in a specific way. You create a C Corp and a retirement plan for it, such as a 401(k), after which your retirement money can be rolled over into the new retirement plan. Then, the plan purchases stock in the new C Corp, and funds become available for operating needs!
The new retirement plan must be available for all employees, including yourself. You’re required to be a fiduciary for this plan, which means you must set the financial best interests of all employees first and foremost. That’s another reason why you want to choose a reasonable income level. Salaries are part of establishing compliance with IRS and Department of Labor regulations regarding ROBS funding, as long as the amount chosen is reasonable. A too-generous income for your title, duties, profits, or industry can be considered contrary to your fiduciary duty.
The IRS also requires you to be an active employee and have an operational role. To use ROBS, you can’t be a passive business owner. As a result of this active employee requirement, many advisors recommend you pay yourself a salary, as it’s a way of proving that you are an employee. However, several other factors can prove to the government that you’re an employee. That means taking a draw is also acceptable — if that works better for you and your business. But you must ensure your income comes from business operations, not directly from your ROBS funds.
Want to know all the ins and outs of ROBS? See our Complete Guide to 401(k) Financing: Rollovers as Business Startups (ROBS).
Need Financing Advice or Payroll Help?
Our team of financial and payroll experts at Guidant Financial can help! We offer advice and consultations on ROBS, compliance with ROBS rules, eligibility requirements, and other forms of small business financing.
We also offer Payroll Services to help streamline the payment process for business owners. Payment processes can be complex and time-consuming for new business owners, but it doesn’t have to be.
Looking for financing for your small business? Pre-qualify today for business financing, or call us at 425-289-3200 to book your FREE business consultation!
“I owe a sense of gratitude to Guidant for helping me get here. It was a turning point for us moving forward.”
— Stephen Such, Falling Sky Brewing