Owner's Draw vs. Salary: How to Pay Yourself as a Business Owner
by Ali Hanckel on Apr 6, 2023 4:06:25 PM
As a small business owner, you have the ability to take money out of your business - sometimes referred to as an 'owner's draw.' This can be a great way to ensure that you are financially set for the future and rewards yourself for all of your hard work. However, it is important to understand the difference between an owner's draw and salary when it comes to paying yourself. In this guide, we'll discuss how each payment type works and the advantages and disadvantages that come with them. Knowing exactly what’s involved will help make sure you have secure financial footing both now and down the road.
What is an Owner’s Draw, and How Does It Compare to a Salary?
An owner's draw is a method for business owners to withdraw funds from their business for personal use. It is essentially a distribution of profits to the owner(s) of a business.
Unlike a salary, a fixed amount paid to an employee regularly, an owner's draw is not guaranteed and can vary depending on the business's profitability. Owners may choose to take a draw periodically or only as needed.
Another critical difference between an owner's draw and a salary is that a draw is not subject to payroll taxes, such as Social Security and Medicare. This can result in tax savings for the owner. However, owners are still responsible for paying income taxes on their draw as it is considered personal income.
It's important to note that not all businesses can take owner's draws. Only certain types of business structures, such as sole proprietorships, partnerships, and LLCs, allow owners to take draws. In contrast, owners of corporations typically receive salaries and may also receive dividends on their shares of stock.
Overall, the decision to take an owner's draw versus a salary depends on the specific circumstances of the business and the preferences of the owner. It's essential to consult with a financial professional to determine the best course of action for your situation.
When is it Better to Take a Salary Instead of an Owner's Draw?
The decision to take a salary or an owner's draw depends on the specific circumstances of your business and your financial situation. Here are some factors to consider when making this decision:
The legal structure of your business can impact your ability to take an owner's draw. For example, if you operate as a sole proprietorship or partnership, you may be able to take an owner's draw, but if you operate as a corporation, you may need to take a salary.
The way you are taxed on your income can also influence whether you choose to take a salary or an owner's draw. Depending on the structure of your business, taking a salary may result in more taxes being withheld at the source, whereas taking an owner's draw may require you to pay estimated taxes.
Related Reading: How Your Business Structure Impacts Your Taxes
If your business has limited cash flow, a salary may be the better option since it guarantees a consistent income. On the other hand, if your business has surplus cash flow, you may be able to take an owner's draw without impacting your ability to pay bills and other expenses.
Personal Financial Needs
Your financial situation can also impact your decision to take a salary or an owner's draw. If you need a steady income to pay private bills, a salary may be a better option. If you have more flexibility in your finances, an owner's draw may provide more financial benefits.
Finally, consider your plans for the business. If you plan to sell the business or take on investors, a salary may be a better option since it provides a more stable income stream. However, if you plan to keep the business long-term, an owner's draw may be a more attractive option.
Ultimately, the decision to take a salary or an owner's draw should be based on your circumstances and financial goals. It is always a good idea to consult with a financial advisor or tax professional before making major financial decisions.
Advantages & Disadvantages of an Owner's Draw Compared to Salaries
An owner's draw and a salary are two methods of compensating business owners for their work in a company. Each method has advantages and disadvantages, and the choice between the two depends on various factors, such as the business structure, cash flow, tax implications, and personal financial needs. Here are some of the advantages and disadvantages of an owner's draw compared to a salary:
Advantages of an Owner's Draw
An owner's draw is usually not subject to payroll taxes, which can result in lower overall tax liabilities for the business owner.
An owner's draw provides more flexibility in terms of the timing and amount of compensation. The owner can take money from the business without setting a fixed salary.
An owner's draw is not subject to mandatory withholdings, which means the business owner can take out as much or as little money as they need without worrying about deductions for taxes, retirement plans, or other benefits.
An owner's draw does not affect the owner's equity in the business. The owner remains the business's sole owner regardless of how much money they take out.
Disadvantages of an Owner's Draw
An owner's draw can be uncertain as it depends on the company's profitability and cash flow. If the company's revenue decreases, there may not be enough money available for the owner to take a draw.
Lack of Stability
An owner's draw does not provide a fixed income stream, which may make it difficult for the owner to plan their finances.
Related Reading: 5 Financial Accounts to Help Manage Your Business Finances
An owner's draw may be less credible to lenders or investors than a fixed salary, which could negatively impact the business's ability to secure financing or attract investment.
Advantages of a Salary
A salary provides a consistent income stream, making it easier for the owner to plan personal finances.
A salary is subject to payroll taxes, but this can be advantageous for some business owners as the taxes are withheld at the source, eliminating the need to pay estimated taxes quarterly.
A salary may be more credible to lenders and investors, which can help the business secure financing or investment.
Disadvantages of a Salary:
A salary is subject to payroll taxes, which can increase the overall tax liabilities of the business owner.
A salary provides less flexibility than an owner's draw. The owner must set a fixed salary, which may be challenging if the business has unpredictable cash flows.
A salary can impact the owner's equity in the business, as it may be viewed as an expense that reduces the company's profitability.
Overall, the choice between an owner's draw and a salary depends on the specific circumstances of the business and the owner's personal financial needs. It is essential to consider the advantages and disadvantages of both methods before making a decision.
How to Utilize an Owner's Draw for Tax Savings & Capital Growth
An owner's draw is a method of withdrawing funds from a business structured as a sole proprietorship, partnership, or limited liability company (LLC). Here are some ways to utilize an owner's draw for tax savings and capital growth:
Reduce taxable income
An owner's draw is not taxable income for the business owner since it is a withdrawal of the owner's equity in the business. Therefore, taking an owner's draw instead of a salary can reduce the amount of taxable income for the business.
Plan for quarterly taxes
Since an owner's draw is not subject to payroll taxes, it is essential to plan for quarterly estimated tax payments to ensure that the appropriate amount of taxes are paid throughout the year.
Reinvest the money
Instead of spending the owner's draw on personal expenses, consider reinvesting the funds into the business. This can help to grow the business and increase its value over time.
Invest in retirement accounts
Owners of small businesses can take advantage of retirement accounts such as a Simplified Employee Pension (SEP) IRA or a Solo 401(k) plan. Contributing a portion of the owner's draw to these accounts can provide tax benefits and help to grow retirement savings.
Consult with a tax professional
It is essential to consult with a tax professional to determine the best way to utilize an owner's draw for tax savings and capital growth. A tax professional can provide advice on tax planning strategies and ensure that the business owner is compliant with tax laws and regulations.
What Strategies Can be Used to Maximize the Benefits of an Owner’s Draw?
Maximizing the benefits of an owner's draw involves careful planning and execution. Here are some strategies that can help maximize the benefits of an owner's interest:
Establish a Budget: To maximize the benefits of an owner's draw, it is essential to establish and stick to a budget. This will help ensure that the business has the sufficient cash flow to cover its expenses while allowing the owner to take a draw.
Monitor Cash Flow: It is crucial to monitor the business's cash flow regularly to determine the amount of money available for an owner's draw. This will help avoid taking out too much money that the company cannot afford to spare.
Consider Tax Implications: While an owner's draw can provide tax advantages, it is essential to consult with a tax professional to determine the optimal amount to take out. Taking out too much money could result in higher tax liabilities.
Be Consistent: To maximize the benefits of an owner's draw, it is essential to be consistent in the amount and timing of the draw. This will help establish a reliable income stream for the owner and allow for better personal financial planning.
Reinvest in the Business: To ensure long-term success, it is important to reinvest in the business. This could involve using some of the owner's draw to finance new projects or equipment or to hire additional staff to increase revenue.
Plan for the Future: When taking an owner's draw, it is essential to plan for the future of the business. This could include setting aside some draws for unexpected expenses or preparing for future growth.
Consider Business Structure: The business structure can impact the owner's ability to take an owner's draw. It is essential to consult with a financial professional to determine the best structure for the business to maximize the benefits of an owner's draw.
Maximizing the benefits of an owner's draw involves careful planning and execution. By establishing a budget, monitoring cash flow, considering tax implications, being consistent, reinvesting in the business, planning for the future, and considering the business structure, business owners can maximize the benefits of an owner's draw while ensuring the long-term success of the business.