What is an Owners Draw vs Payroll When I Pay Myself As A Business Owner?Nov 23, 2022
There is always a lot of confusion around how to pay yourself as a business owner. This was a question that popped up again in our Free Facebook Group so we want to dig deep on it now!
Before we do that I also highly recommend checking out previous Blog Post and Podcast Episodes related to this:
There are a few things we want to discuss here:
- The various ways a business owner may be able to pay themself from their business.
- The options you have available to pay yourself based on your specific business entity.
What Options May Be Available to Pay Myself As A Business Owner and How Are Each Taxed?
These are the options available but not all of them will be available to you based on your entity type. We will talk about that next.
- Owner Draw or Distribution
- Description: This is simply the act of transferring money from the business bank account to your personal account. Or writing a check, taking cash out, etc. Simply put it is just taking business funds and moving them to you personally.
- Tax Treatment: There is no tax withholding on a draw but a draw is also NOT considered a business expense and therefore does NOT reduce your business profit. Generally stating you will pay your normal ordinary income tax on the profit of your business and potentially self-employment taxes depending on your entity type.
- Description: The act of payroll requires payroll tax withholding, tax form filing, and payments to various government agencies. This is for an actual W2 employee (which for some entities includes the owner as well). We recommend doing payroll through an actual software to help simplify this process. Our recommendation is Gusto.
- Tax Treatment: Payroll is a business expense so unlike draws or distributions, it does reduce your business income. However since it is payroll it will turn into new taxable income to you in the form of W2 income on your personal tax return. Generally this would be subject your normal ordinary income tax rate, FICA (Social Security and Medicare), along with Federal and potentially state unemployment taxes.
- Guaranteed Payment
- Description: These are usually part of a partnership agreement and are a payment that is agreed upon that is guaranteed to a specific partner regardless of profit or loss of the business.
- Tax Treatment: This is a business expense and would reduce business income/profit but the partner receiving it will report all of that income received on their personal return and generally would be subject to ordinary income taxes and self employment taxes.
- Description: These are more rare and work similar to an owners draw or distribution but often times require some extra year-end paperwork.
- Tax Treatment: These are less common for your typical small business owner and get taxed at different rates depending on if it is a qualified or non qualified dividend.
Based On My Entity Type, How Should I Pay Myself?
- Sole Proprietor or Single Member LLC
- You would pay yourself via an owners draw. You are actually not allowed, by law, to pay yourself via payroll.
- You would pay yourself via an owners draw and/or guaranteed payment. Here again, you are not allowed, by law, to pay yourself via payroll.
- S Corporation
- You would pay yourself by BOTH a distribution and payroll. Remember when we talk about the advantages of S Corps we mention that you are required to take a reasonable salary but that only makes up part of your income, the rest of it comes in the form of distributions.
- C Corporation
- You would pay yourself via a dividend and a salary.
My Business Bank Account Is Empty, Why Am I Still Showing A Profit?
This is something that often comes up during tax season so I want to take the time now before year-end to go through it so you can make decisions before year-end.
- In this discussion we are assuming cash basis accounting. Items get recorded as they occur (incoming cash is a sale when it comes in and an expense is recorded when it is spent).
- We also need to understand the difference between an income statement and balance sheet. We did an entire series on this awhile back that you can check out here.
- As discussed above, owner draws are not expenses so you transfer money to your personal account via owner draw, the money leaves the business but does not reduce income.
- Business Sales: $200,000
- Business Expenses (Pre-Payroll): $80,000
- Payroll Expenses (including payments to S Corp Owners): $50,000
- Owner Draw: $40,000
- Business Profit: $70,000 (Business Sales – Business Expenses – Payroll Expenses) – Note: owner draw did not reduce profit
- Bank Balance: $30,000 (Sales – Expenses – Payroll – Draw) – Note: This is assuming the only activity in the business account was the items in the facts with no beginning balance.
- So in this example the business has profit of $70,000 but a business bank balance of only $30,000 because $40,000 of that was related to owner draws which is a balance sheet item, not an income statement item!
- Other Reasons:
- Loan Payments: Only the interest piece of a loan payment is deductible, the principal is not (this is just a balance sheet item).
- Credit Card Payments: Get the tax deduction when transaction occurs not when paid. Could cause a timing issue with a CC balance in prior year that wasn’t paid until this year.
Always remember, with a pass through entity you are taxed on the profit of the business regardless of how much money you leave in or take out of the business.
What Do I Need To Know About Paying Myself Before Year-End and Key Take-Aways
- The most common types of small business owners we see are Sole Props/Single Member LLCs or S Corps which means you would only need to worry about draws and/or salary.
- Taking an owners draw is actually very simple, do not over complicate it. Simply take money from your business bank account and put it in your personal account.
- If you need money personally, ALWAYS transfer it first to your personal account and then spend it. Do not start paying for personal items out of your business bank account.
- If you operate as a Sole Proprietor, Single Member LLC, or Partnership you are not legally allowed to pay yourself, as an owner, via payroll.
- If you operate as an S Corp you are REQUIRED to take a reasonable salary (payroll) and if you have not done that yet this year, be sure to run a catch-up now.
Keep all of this in mind as we are closing out the year because once the calendar rolls over to the New Year, the majority of tax planning opportunities get tossed out the window.
You have time now, take a couple hours to strategize and implement so you can ensure when you file your tax return you are paying the lease amount in taxes as legally possible!
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