Congratulations! Your small business has moved beyond the initial start up 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.
As a sole proprietor, a partner in a partnership, or an owner of your own S corporation, you should pay yourself a salary. That salary is subject to various withholdings, including state and federal taxes and social security payments.
The IRS requires that you earn reasonable compensation for the type of work you are doing. As a guideline, the government suggests choosing an amount similar to what another business would pay someone to do what you do.
Let’s say it’s the end of the month. The company’s bills and everyone on staff has been paid their salary – including you – and you have money left over that doesn’t need to be reinvested in the business. You may choose to take a draw to pay yourself additional money beyond your salary.
A draw is a payment from the business to you that is not immediately subject to any federal or state withholdings. However, it will subjected to taxes down the line, and thus you may need to make estimated quarterly payments on this additional income to prevent a huge bill when you file your income-tax return.
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.”
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.