The days of a regular paycheck may feel long gone, but it’s still important to pay yourself. It’s the best way to keep your expenses in check and ensure you put enough money back into the business to grow.
There are a few different ways to pay yourself. We’ll take a look at the fundamentals to determine which one is best for your business:
Salary
When you earn a salary, you get paid a fixed amount each pay period (usually weekly or bi-weekly). It differs from earning a fee that depends on how much work you do, sometimes called piecework. Federal and state taxes are automatically withheld from your paycheck when you choose to pay yourself a salary. Building an emergency fund from scratch
The IRS mandates that you earn “reasonable compensation,” which means that your income should be equivalent to what others in your business are receiving for similar work, whether you choose different ways to pay yourself. Fair compensation can be established by examining the company’s earnings, costs, and other elements.
If you’re thinking about paying yourself a salary, it’s important to remember that your finances should remain separate from your business finances. It can be done by maintaining a business bank account and keeping your expenses low.
Another option for small business owners is to take an owner’s draw or a distribution from the company’s profit or capital. This method is more flexible than a salary because it allows you to withdraw funds from your business anytime. However, this can lead to cash flow issues if the business needs to make more money to cover your payments. It’s also a good idea to keep track of your payments and record them correctly. It can be done by utilizing accounting software.
Owner’s Draw
A “draw” is a payment from your business to yourself based on the company’s profit. It’s different from a salary, a set amount paid regularly. Your draw can be adjusted based on business profits and cash flow. This method is available to sole proprietors, partnerships, and LLCs that aren’t C corporations.
A draw can be made in any form of payment, including non-cash. It’s a flexible option that gives you more control over when and how much to withdraw. For instance, a prominent owner’s draw at the end of a profitable quarter would help you manage cash flow in the following quarter.
One major downside to this approach is that IRS taxes aren’t withheld, as they are when you receive a salary. It can result in you owing self-employment tax in addition to what you report on your income taxes.
A draw may also need to be increased to cover your current expenses, and you’ll need to ensure you have enough money left over to pay for the rest of the year. It’s important to weigh this decision carefully when deciding whether to use this method.
Dividends
New investors may need to familiarize themselves with dividends and how they relate to the overall investment process. Dividends are payments in cash or stock that public companies pay to their shareholders. The company’s board calls on whether or not to pay a dividend, how much to pay, and when. The company may also decide to reinvest its profits instead of paying dividends.
Investors who purchase stocks that pay dividends look at this income stream to get a regular check from the company they have invested in. Many investors will then reinvest these dividends to grow their portfolios. In addition to being a source of extra income, dividends can be seen as a sign that the company is stable and financially healthy.
As a business owner, you should always be aware of the tax implications of any form of self-payment from your business. If you need help handling these transactions, you should consult a qualified accountant to help ensure your transactions are processed correctly and efficiently.
It’s important to note that dividends are more flexible than a salary, mainly if your business is structured as a C corporation. Officers of C corporations are generally paid on a salary basis and subject to all standard payroll taxes. However, owners of S corporations can take “dividend draws,” which aren’t subject to the same standard payroll taxes as salaries.
Taxes
While you probably know that taxes are compulsory contributions your state or federal government levied to pay for things that society needs but can’t pay for individually, you may need to realize their impact on the money you get to keep, save, and spend. Taxes provide a wide variety of services, from clean water running out of your faucet to police keeping your community safe, and they’re an essential part of every person’s life. No one likes paying them, but understanding how they relate to different ways of paying yourself will help you make better financial decisions.
When you’re an employee, your employer automatically cuts income and employment taxes out of each paycheck before you receive it. These taxes are then sent to the IRS on your behalf, where they’re combined with state and local income taxes you’ve paid to create your total taxable income for the year.
If you’re a business owner, the type of business entity you choose impacts how your profits are distributed to you. For example, a single-member LLC that elects to be taxed as an S-corporation will only pay FICA, Medicare, and Social Security taxes on the salary or wages you pay yourself (colloquially known as “self-employment tax”) rather than on all of the business’s profits—significant tax savings.
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