Running a successful business is not for the faint-hearted. It takes hard work and dedication. As your business starts making a profit, you’ll likely want to take some cash out and enjoy the fruits of your hard labor.
If you are wondering how to pay yourself as a small business owner, you are not alone.
This is a common question that small business owners have. You need to know the right way to do it to avoid tax issues and potential harm to your business.
Now, let’s get into the nitty-gritty of how to pay yourself as a small business owner based on your business type.
Sole Proprietorships
If you’re a sole proprietor, figuring out how to pay yourself as a small business owner is straightforward. Just transfer funds from your business bank account to your personal account or write yourself a check.
It’s like paying yourself a salary. This is called an “owner’s draw”. In a Sole Proprietorship business profits are subjected to taxation on the sole proprietor’s personal tax return.
An example of a sole proprietor paying themselves
Suppose you are the owner of a sole proprietorship, and your business generates $100,000 in net profits for the year after deducting eligible business expenses. As a sole proprietor, you report your business income and expenses on Schedule C of your personal tax return.
Income Tax Calculation
The $100,000 net profit from your business would be subject to federal income tax. Applying a 24% tax rate, the income tax owed would be $24,000 (24% x $100,000).
Self-Employment Tax Calculation
As a sole proprietor, you are responsible for paying both the employer and employee portions of Social Security and Medicare taxes, commonly referred to as self-employment taxes. The 2023 self-employment tax rate is 15.3%.
To calculate the self-employment tax, you would multiply the net profit by the self-employment tax rate. In this case, the self-employment tax owed would be $15,300 (15.3% x $100,000).
Owner’s Draw and Personal Tax Obligation
After accounting for income tax and self-employment tax, you may choose to take an owner’s draw from the remaining profits. Let’s say you decide to take a $50,000 owner’s draw.
The owner’s draw itself is not subject to income tax because it represents a distribution of the already-taxed profits. It’s important to note that the $50,000 owner’s draw reduces your personal equity in the business but does not affect the taxable income already calculated for income tax and self-employment tax purposes.
Therefore, based on this example, your federal income tax liability would be $60,700, and your self-employment tax liability would be $15,300. The owner’s draw of $50,000 would not be subject to additional income tax.
Please keep in mind that this is a simplified example, and actual tax calculations may vary based on several factors, including tax rates, deductions, credits, and other personal circumstances. Our team at LedgersKept can help you navigate this to ensure compliance.
Partnerships
In a partnership, you’re in it together with one or more people. When it comes to how to pay yourself as a small business owner, within a partnership, you have a couple of options.
You can take guaranteed payments, which are like salaries, or go for partner draws. Guaranteed payments are deductible business expenses, while partner draws are based on your partnership agreement.
Guaranteed Payments
Are a form of compensation made to partners in a partnership for the services they provide to the business. In a partnership, partners are actively involved in running the business and contributing their skills and expertise. To recognize their contributions, the partnership may agree to make guaranteed payments to partners, which are predetermined and fixed amounts.
It is important to remember that guaranteed payments received by partners are considered taxable income for the individual partners. The partners must report these payments on their personal income tax returns and pay taxes on them accordingly.
While guaranteed payments are taxable income, under certain circumstances, they are not subject to self-employment tax. This can be advantageous for partners as they may not be required to pay the additional Medicare and Social Security taxes on these payments. Note, this will ultimately depend on whether or not your entity was set up correctly so it’s advisable to speak to a tax professional first.
Partner’s Draws
While both partners’ draw and owner’s draw involve taking money out of the business. Partners draws are associated with partnerships and multi-member LLCs, where multiple owners share in the business’s profits. Owners draws on the other hand are typically associated with sole proprietorships or single-member LLCs, where there is a single owner.
As per the example above for the “owner’s draw,” the same would apply for the partner’s draw, however, it would also depend on the agreement between the partners. Draws are usually distributed based on their shareholding percentage.
In a general partnership, you do not pay income tax through the business. Instead, the profits and losses of the partnership “pass through” to you, the individual partners. You will report your share of the partnership’s income or losses on your personal income tax return.
The partnership will file an informational tax return called Form 1065 to report its income, deductions, and other relevant information, but the partnership itself does not pay income tax. You will include your respective share of the partnership’s profits or losses on your personal tax return and pay income tax on that amount at your individual tax rate.
This pass-through taxation characteristic of a partnership allows you to be taxed directly as an individual rather than as a separate business entity.
Before Paying Yourself
There are a few important things to keep in mind before paying yourself as a small business owner.
1. Cash Flow
When your business bank account is brimming, it’s tempting to take out a large chuck for personal use. But just because there’s money in the account, that doesn’t mean that it’s profit. There are always upcoming payments, like bills to pay, tax obligations, employee costs and unforeseen expenses such as machinery replacements. Avoid crippling your business by drawing money without a clear understanding of your future cash flow movements.
2. Create A Budget
If you’re wondering how much to pay yourself as a small business owner, start with a budget. Create a twelve month, realistic budget that factors in all your income and expenses. That will help you determine how much you can realistically afford to pay yourself.
3. Find A Balance
Our advice is to find a balance between how much you pay yourself as a small business owner and how much you leave in your business. Remember, as your business grows you should be able to pay yourself more. Set a target to add a certain amount each quarter into a cash reserve in your business. This money can then be used to fund expansion and cover any emergencies or problems that arise.
Important Reminders
Remember these golden rules, no matter what type of business you have.
Keep Personal and Business Funds Separate
Don’t mix personal and business funds. It’s a recipe for trouble. Use separate bank accounts and avoid paying personal expenses from your business account or vice versa.
Seek Professional Advice
When it comes to “How to pay yourself as a small business owner”, it’s always wise to seek advice from online bookkeeping professionals. We can guide you through the specific regulations and help you make the right decisions based on your unique circumstances.
Reaching the milestone of figuring out how to pay yourself as a small business owner is exciting but it’s important to do it correctly to avoid any negative consequences.
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