The Right Way To Pay Yourself As A Business Owner

f you’re a small business owner and thinking about paying yourself for the first time, there are a handful of things to consider first. The resounding theme we hear is that paying yourself can be confusing, so we consulted an expert to help simplify the process.

CPA Sean Palmer, the founder of Clifton Tax Pro and a longtime Novo user, says there isn’t a one-size-fits-all solution when it comes to the right way to pay yourself. “In my opinion, paying yourself a salary is going to be business-dependent, needs-dependent and structure-dependent.” 

In this article, we asked Sean to provide insight on the right way to pay yourself as a business owner. We break down 4 things to consider:

1. Methods of Payment
2. Determining a Salary
3. Tax Implications
4. Setting Up Payroll 

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Methods of Payment

There are two primary methods of payment that small business owners can consider: the salary method and the owner’s draw. Which of these two methods is right for you will depend on a few factors, including your business structure. Whether your business was set up as an LLC, a corporation, a partnership, or a sole proprietorship will also inform your choices.

Salary Method

Best for: S-corps, C-corps

With the salary method, you will put yourself on a regular pay schedule and receive recurring payments of a set amount. Your salary can be based on hours worked, or a reasonable flat rate, but you pay yourself on a regular schedule. According to the Bureau of Labor Statistics, the biweekly pay period is the most common. Your salary can be adjusted up or down as your business grows. 

The salary method is available for any kind of business owner, but there are strict rules if yours is a C-corp or S-corp. Legally you must take a regular salary with withholdings for Social Security, Medicare, federal and state income taxes.

Owner’s Draw

Best for: LLCs, Partnerships and Sole Proprietorships. S-corp owners can also take an owner’s draw in addition to their salary.

Also known as a “draw out”, this is when a business owner transfers money to their personal account as needed. It does not have to be on a regular schedule, nor does it have to be a predetermined amount. But Sean reminds business owners about tax obligations. “This money does not go through the payroll process. It is the responsibility of the owner to calculate their own taxes from this amount and pay those.”

Note the amount of your draw should not exceed the equity you have in the business. 

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Determining a Salary

Sean says a reasonable salary should be based on industry benchmarks you research and document. “If you were to hire an employee to do all that you do, let's call them a general manager…what are they worth? Is it $100,000? Is it $80,000? That would be where you want to benchmark yourself as a reasonable salary. It's about trying to find what the market rate would be for any other employee doing the tasks that you do.” 

If you are the owner of an S-corp, there are additional guidelines you must follow when setting your salary. If you are not an owner of an S-corp, you have more flexibility in determining your salary. Instead, you can base this decision on the state of your business, your financial obligations, and your expansion plans.

• What are my financial obligations? In addition to your business's operating expenses, like rent, utilities, and taxes, your financial obligations include what your household needs to stay afloat. This means your living expenses, and debt repayments, like your mortgage. While these budgets should remain separate, accurate calculations can help you determine the range. 
• What are my expansion plans? Sean says, “If you have a fixed asset intensive business such as manufacturing, you have to buy inventory, you have to store it, you might have to ship it, etc, then these types of capital assets may need to be purchased with cash reserves or financing. So you've got expansive assets that you need to purchase. In that case, you're going to need to withhold some of that money, leave it in the business, for expansion and just for replacement of existing assets as they need to be replaced.”

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Tax Implications

The tax difference between taking a salary, or an owner's draw comes down to whether you will pay payroll taxes associated with a salary, or potential income taxes associated with an owner's draw. 

• Payroll taxes: These are automatically withheld funds on your paycheck that contribute to Social Security and Medicare. This means that there is increased tax liability for the owner. 
• Income Taxes: Since an owner’s draw doesn’t have payroll taxes, it could mean temporary tax deferral. But keep in mind, you are still subject to income tax rules. Sean says the easiest way to think about this is understanding that, “Everything is coming back to you. While it can be set aside, at the end of the day, everything flows through to the business owner.” In other words, you’ll still have to pay the same amount of taxes at the end of the year. 
• Timing: As for the timing of these payments, Sean says, “Taxes are due as earned. So you can't just not pay any taxes until the end of the year. If you do, the IRS will penalize you, and charge you interest out the wazoo!”

The tax rules change every year which is why Sean says, “There's fear related to doing payroll taxes correctly.” You’ll want to consult with the IRS on the current Social Security and Medicare tax rates for both the employee and the employer.

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Setting up Payroll

Once you’ve made all the strategic decisions about the right way to pay yourself, you need to set up your payroll process. 

You’ll decide whether you want to process your payroll yourself in house, or outsource it to a third party. You can also decide whether you want to use spreadsheets, desktop software, or cloud-based payroll software. For example, Novo Payroll can help you simplify your payroll needs. With automated tax calculations and filing, you can bid farewell to learning those tedious new tax rules, and use of spreadsheets. Moreover, it seamlessly integrates with Novo's budgeting tools and working capital to make sure that your team always gets paid on time.

When making these decisions, think about your business's size, how complex your payroll would be, and your budget. Sean recognizes the added cost of outsourcing payroll, but he says the time savings and the guarantees of compliance are far more valuable; “If you do payroll in house, there may not be a financial cost, but there's a time cost. You may not have the skill to do it yourself.” 

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Conclusion

When it comes to paying yourself the right way as a business owner there are a lot of strategic decisions you have to make. You have to decide the method of payment, either a salary or an owner's draw, and you have to determine your salary, which will be based on industry benchmarks and your financial obligations.

Once you have settled on the right number, you have to plan how to pay your taxes and how to set up your own payroll. 

The biggest takeaway Sean has for small business owners on the right way to pay yourself is to consult with an expert! Here at Novo, we recommend working with people and tools you trust — whether that's software, an accountant, or both.

Tax laws and labor regulations can change, he says and if you are not in compliance there can be penalties and legal issues. He says, “Payroll is one of those things that you can't mess up. It is absolutely critical and time sensitive.” 

Your payroll not only ensures financial stability and employee trust, it can increase employee morale, productivity and operational efficiecny.  If it’s done improperly, you could risk compliance issues, penalties and your overall company reputation. 

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Novo Platform Inc. strives to provide accurate information but cannot guarantee that this content is correct, complete, or up-to-date. This page is for informational purposes only and is not financial or legal advice nor an endorsement of any third-party products or services. All products and services are presented without warranty. Novo Platform Inc. does not provide any financial or legal advice, and you should consult your own financial, legal, or tax advisors.

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