How To Determine How To Pay Yourself as a Small Business Owner

Banking
8 min
Feb 10, 2023
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In many cases, small business owners tend to be the last ones to get paid. Sometimes, this is due to a lack of profit, while other times the owner simply doesn’t know how to pay themselves.

Should you take a salary? What about an owner’s draw? How much should you be paying yourself as a business owner?

Knowing which payment methods make the most sense for your business and factors to consider when determining how to pay yourself as a small business owner will go a long way in your decision-making process.

In this article, we share payment methods, considerations, and common mistakes business owners make when paying themselves.

How Do Business Owners Pay Themselves?

Small business owners typically pay themselves through one of the following methods:

  1. Drawing a salary as an employee of the business
  2. Taking an owner’s draw
  3. Distributing profits through dividends
  4. Withdrawing funds as a shareholder loan
  5. Combination of the above methods

Taking a salary or an owner’s draw are the most common methods for paying yourself as a business owner.

Understanding Owner’s Draw vs. Salary

Some businesses confuse an owner’s draw with salary. Here are the key differences:

Owner’s Draw:

  1. Not taxed as income
  2. Not based on hours worked or specific job duties
  3. Taken from business profits
  4. May not have limits on amount or frequency 

Salary:

  1. Taxed as income
  2. Based on hours worked or specific job duties
  3. Paid from business revenue
  4. May have limits on amount and frequency set by the employer

Owner’s Draw

An owner’s draw is a term used in small businesses to describe when a business owner takes money out of the company’s funds for personal use. 

This is different from a salary and is usually not taxed as income. It is seen as a return on the owner’s investment in the business.

Pros and Cons of an Owner’s Draw

Pros of an owner’s draw:

  1. Flexibility: Business owners can withdraw funds as needed without restrictions on the amount or frequency. 
  2. Tax Savings: Draws are not taxed as income, only as dividends if the funds are classified as such.
  3. Easy access to capital: Business owners have immediate access to business funds for personal use.

Cons of an owner’s draw:

  1. Reduced company funds: Frequent withdrawals can negatively impact the company’s financial stability.
  2. Difficulty in tracking: Draws may not be properly accounted for, leading to confusion and potential tax issues.
  3. Personal liability: If the business runs into financial difficulties, the owner’s personal assets may be at risk.
  4. Negative impact on credit score: Large withdrawals may lower the business’s credit score and affect its ability to secure future loans.

Salary

A salary is a form of fixed and regular payment for work performed, typically paid monthly or bi-weekly. 

Salaries are typically offered to employees, including business owners who choose to pay themselves as employees rather than taking an owner’s draw or distributing profits through dividends.

Pros and Cons of a Salary

Pros of taking a salary as a business owner:

  1. Predictable income: Having a set salary can provide a sense of financial stability and predictability.
  2. Tax benefits: Salaries are taxed as regular income, which may have lower tax rates than other forms of business income.
  3. Improved credibility: Paying yourself a salary can convey a professional image to employees, partners, and customers.
  4. Better record-keeping: Paying a salary can simplify accounting and tax reporting.

Cons of taking a salary as a business owner:

  1. Reduced flexibility: A set salary may limit the owner’s ability to withdraw funds as needed for personal or business expenses.
  2. Increased tax liability: Paying a salary increases the owner’s taxable income, potentially increasing their tax burden.
  3. Reduced profits: paying a salary reduces the business’s profits, potentially impacting its financial stability.
  4. Complex payroll processes: The process of paying yourself a salary requires additional record-keeping, reporting, and compliance with payroll tax laws.

Distributing Profits Through Dividends

Distributing profits through dividends is a method used by corporations to pay their shareholders a portion of the company’s earnings. Dividends are usually paid in cash, but they can also be paid in the form of stocks or other assets.

Pros and Cons of Distributing Profits Through Dividends

Pros of distributing profits through dividends:

  1. Shareholders receive a tangible return on their investment, which can increase shareholder confidence and loyalty.
  2. Dividends can serve as a signal to the market of the company’s financial stability and future prospects.
  3. Dividends can provide a steady stream of income for shareholders, which can be particularly attractive for retired individuals or those with low-risk investment portfolios.

Cons of distributing profits through dividends:

  1. Paying dividends reduces the amount of retained earnings that can be used for business growth and expansion.
  2. Dividends are taxed as personal income, which can reduce the overall return for shareholders.
  3. Companies that consistently pay high dividends may face criticism for not reinvesting earnings back into the business.

Withdrawing Funds as a Shareholder Loan

Withdrawing funds as a shareholder loan is a method used by business owners to take money out of their company while keeping the funds as a loan rather than a distribution of profits.

The loan is typically documented with a promissory note and may have a set repayment schedule and interest rate.

Pros and Cons of Withdrawing Funds as a Shareholder Loan

Pros of withdrawing funds as a shareholder loan:

  1. The loan can provide a flexible way for the owner to access funds without reducing the company’s retained earnings.
  2. The loan can be structured with an interest rate, which can provide a return on the funds.
  3. The loan can be taxed as interest income, which may be taxed at a lower rate than distributions of profits.

Cons of withdrawing funds as a shareholder loan: 

  1. The loan must be repaid, which may impact the owner’s personal finances and the financial stability of the business.
  2. The loan must be documented and tracked to ensure compliance with tax laws. 
  3. If the loan is not repaid, it may negatively impact the owner’s credit score.

When considering how to pay yourself as a small business owner, it’s important to consult a financial advisor to ensure that you take the best approach based on your specific business and financial situation.

How Business Classification Can Determine the Best Way for Business Owners To Pay Themselves

The classification of a business can have a significant impact on how much to pay yourself as a small business owner. The most common classifications are as follows:

  1. Sole Proprietorship: Business owners who operate as sole proprietors do not have a legal distinction between their personal and business finances. They typically pay themselves through an owner’s draw or by paying themselves a salary, which is reported as personal income on their tax return.
  2. Partnership: In a partnership, the partners split the profits and may pay themselves a salary or take an owner’s draw. The payment method should be specified in the partnership agreement.
  3. Limited Liability Company (LLC): In an LLC, owners are known as members. They can choose to pay themselves a salary or take an owner’s draw. The method of payment should be specified in the operating agreement.
  4. Corporation: In a corporation, owners are shareholders. They can pay themselves a salary if they are also employees, or they can receive dividends from the company’s profits. The method of payment should be specified in the bylaws.

Business owners should consult with a tax professional to determine the best way to pay themselves based on their business classification and individual circumstances.

5 Factors To Consider When Paying Yourself as a Business Owner

Paying yourself as a business owner takes careful consideration. Here are a few factors to consider before deciding which method is best for you and your business:

  1. Business profitability: Evaluate the financial health of the business and its ability to sustain regular payments to the owner.
  2. Personal financial needs: Take into account your personal financial situation, including living expenses, debts, and savings goals.
  3. Tax implications: Structure the owner’s pay in a tax-efficient manner, taking into account the tax implication of different payment methods and the impact on the business’s taxable income.
  4. Business growth and future goals: Consider the business’s growth plans and future financial goals, such as expanding the business, hiring employees, or retiring.
  5. Industry standards: Keep in line with industry standards and stay competitive with similar businesses in the same market.

Business owners should carefully consider each of these factors and consult with a tax professional to ensure they’re paying themselves in a way that is financially sustainable for the business and their personal finances.

How Often To Pay Yourself as a Small Business Owner

As a business owner, you can pay yourself as often as you prefer, as long as you can cover your business expenses and financial obligations.

Some business owners pay themselves a salary regularly, such as weekly or monthly, while others may opt for a less frequent schedule or draw funds as needed.

Your pay frequency should be determined by your business’s financial stability and personal financial needs.

6 Common Mistakes To Avoid When Paying Yourself as a Business Owner

Many new business owners make mistakes when determining how to pay themselves. To ensure the financial health of your business, avoid these common mistakes:

  1. Not separating personal and business finances: Keeping personal and business finances separate helps you get a clear picture of your business’s financial health.
  2. Not paying yourself a reasonable salary: Paying yourself too much or too little can hurt your business. You should pay yourself a salary that aligns with industry standards and not what you would pay an employee for a similar role.
  3. Neglecting to pay taxes: Make sure you set aside money to pay taxes on your salary to avoid any tax liabilities in the future.
  4. Not having a budget: Not having a budget in place can lead to overspending and financial instability for your business.
  5. Not having an emergency fund: It’s important to have an emergency fund in case of unexpected events. This way you don’t have to dip into your salary to cover unexpected costs.

Not reviewing your financials regularly: Regularly reviewing your financials will help you make informed decisions about your salary and the overall financial health of your business.