No matter how much you love your work, you can’t work for free indefinitely. Business owners and entrepreneurs often do not pay themselves or draw an amount from their business in the initial years; instead, they invest that money back into the organization to stabilize it. After a few months or a year, when the business starts to expand and establish itself in the market, they begin to pay themselves for their hard work. When paying yourself as a business owner, several key factors may come to mind, such as what amount you should pay yourself and which compensation method—draw or salary—best suits you.
The amounts and methods you choose should also comply with certain guidelines. This makes the entire process quite complicated and confusing. At times, it depends on your discretion, type of business, profits, and cash flow. If you need a professional to help sort this out, you may consult a CPA in Louisville KY.
What is an owner’s draw?
Taking money out of your company’s account to pay yourself or cover other expenses is known as an owner’s draw. Most small business owners who operate as sole proprietorships pay themselves by means of the draw method as opposed to receiving a salary. A salary is paid in fixed amounts at the end of every month, but with the draw method, you have the advantage of selecting the amount you want to draw and when you want to do it.
You can take larger draws when your business makes a huge profit, but this also means you may have to take smaller or even no draws when the business is experiencing a downturn. This method can potentially increase your tax liability, i.e., taxable deductions.
For example, if a café owner has a sole proprietorship model and takes out the required money from the business account, that will be referred to as a draw. In this case, the individual can withdraw a combination of the required amount plus the capital invested in the business earlier, both at the same time.
The café owner’s earnings from the business will be reflected in their personal account, and therefore, they will have to pay estimated tax payments and self-employment taxes on those earnings. It implies that the owner would not have to pay taxes on the drawn amount, as that has already been paid earlier or will be taxed in the current financial year.
This mode of payment perpetually reduces the owner’s business equity. (The amount you invest in your business, excluding all liabilities and assets in the form of equipment and money, is referred to as owner’s equity.) It is important to note that your drawn amount cannot exceed your net equity (owner’s equity).
What’s a Salary?
A salary, as most of you are aware, is the set amount that a business owner gets every pay period. In an organization or corporation, employees are paid their designated salaries. Similarly, with this payment method, business owners give themselves a reasonable paycheck every month. Even so, you are free to choose how much of your pay you wish to take home.
This method is predictable, requires less administrative work, and can be scheduled every pay cycle. However, it requires regular cash flows to pay the owed salaries to yourself and the employees, which can be difficult to manage.
With a salary, taxes are deducted upfront with every paycheck rather than at the end of the year, giving you a clearer picture of your business and personal finances. Moreover, the profits earned in your business can still be paid out as bonuses.
