How to Pay Yourself as a Small Business Owner in 5 Steps

Deciding how to pay yourself is a necessary aspect of business ownership. This guide outlines practical steps to select the most appropriate compensation method based on your business structure and financial situation. Whether you opt for a salary, a draw, or an owner’s draw, the goal is to ensure your payment strategy is both sustainable and compliant. Let’s explore how you can secure a compensation plan that supports both you and your business.

A graphic that is used for an article discussing how to pay yourself as a business owner. The graphic depicts a independent contractor working from a coffee shop.

1. Choose a Payment Structure

Salary: Ideal for any business that chooses a formal payroll structure, such as corporations and certain LLCs that are taxed as corporations. Setting a fixed salary for yourself enables you to receive a consistent income and can simplify the management of business finances. This method involves regular payroll processing, including tax withholdings and compliance with employment tax regulations. Opting for a salary is particularly effective for businesses that benefit from demonstrating a clear separation of personal and business finances, such as those seeking to attract investors or secure business loans. It also provides predictable financial planning for owners who depend on a steady income stream to manage personal and business expenses.

Draw: Suitable for sole proprietors and partnerships, a draw allows business owners to take money directly from business earnings as needed. This method does not treat the withdrawals as a salary, so it does not involve payroll taxes at the time of drawing. Owners must meticulously record these withdrawals because they will need to report them on their personal tax returns. This flexibility is advantageous for businesses with fluctuating income.

Owner’s Draw: This term is also used more broadly for any business owner who withdraws earnings directly from their business, including those operating LLCs, sole proprietorships, and partnerships. The specifics can vary: LLCs, for instance, may choose this method if taxed as a sole proprietorship or partnership. Like draws, these are not initially subject to payroll taxes but are taxed as personal income, making it necessary for owners to maintain accurate financial records.

Pro Tip: The primary difference between a “draw” and an “owner’s draw” is that “draw” typically refers to withdrawals by sole proprietors and partners, while “owner’s draw” is more commonly associated with withdrawals in LLCs, although the fundamental concept of non-salaried withdrawals applies to both.

2. Assess Your Business’s Financial Health

Before deciding how to pay yourself, it’s crucial to understand your business’s financial situation. If you don’t already use accounting software, consider starting with basic tools like spreadsheets to track your revenues, expenses, and profits. This manual method can help you gain a clear picture of your cash flow and ensure that your compensation doesn’t jeopardize your business’s operations. For more accuracy and ease, you might explore affordable accounting software options tailored to small businesses. These tools can automate much of the financial tracking and provide more precise data to guide your decisions on compensation. Always ensure you have a financial buffer in place to maintain stability during fluctuating market conditions.

3. Set a Fair Compensation

Determining fair compensation requires a nuanced understanding of your unique contributions to the business and its financial performance. Start by conducting a detailed market analysis to find salary data for similar roles in your industry and region. Resources like Glassdoor and Salary.com, can be helpful when performing this exercise. Evaluate your role(s), responsibilities and the hours you commit to the business. Ask yourself, are you doing multiple jobs within your company? Adjust your compensation accordingly. 

Next, analyze your business’s profitability. Your pay should reflect the business’s ability to sustain it. If your business is in an early stage or experiencing lower profits, consider a lower salary with the potential for bonuses based on performance milestones. Also, consider non-monetary benefits that could form part of your compensation. These might include health insurance, retirement contributions, or even equity if your business structure allows.

Pro Tip: Tracking your hours early on helps you understand how much effort goes into different aspects of your business, providing a basis to adjust your pay realistically as your business evolves.

Engage with a certified public accountant (CPA) who can provide tailored advice based on your specific business structure and financial situation. They can help you understand how different compensation methods affect your tax liabilities and help you adhere to IRS guidelines. For instance, if you choose a salary as your payment structure, your CPA may assist in setting up the payroll withholdings and advise on quarterly tax payments. If choosing a draw, they may guide you on making estimated tax payments to avoid penalties. Professional guidance is vital to making informed decisions that protect your business and personal finances.

5. Regularly Review and Adjust Your Pay

Establish a review process that occurs at least annually. During these reviews, evaluate changes in business revenue, profit margins, and your personal financial needs. If your business experiences significant growth, you may need to adjust your salary or draw to reflect increased responsibilities or to reinvest profits to support further growth. Conversely, during slower periods, you might need to moderate your compensation to maintain business stability.

Reinvest In Yourself

Reinvesting profits back into your business is a strategic choice that may accelerate your growth. Allocating earnings back into your business may allow you to fund expansions, improve facilities, or upgrade technology, like that fancy new accounting software you’ve always wanted. This proactive approach boosts your business’s capabilities and increases its value over the long term.

Practical Example of Reinvesting in Yourself

A small business owner decides to allocate 20% of their annual profits to personal and professional growth. They invest in a specialized training program to deepen their expertise and upgrade to more advanced software that simplifies daily tasks. These investments directly enhance their ability to serve their customers better and handle more work efficiently.

Now, It’s Your Turn

Now that you are equipped with the foundational knowledge on payment structures, it’s your turn. Evaluate your business’s current financial health and choose a suitable payment structure, be it salary, draw, or owner’s draw. Set up the necessary systems and work with a financial advisor to ensure you comply with tax regulations. As your business evolves, continuously revisit and adjust your compensation to align with your financial needs and business goals.

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