When to Start Paying Myself on Payroll?

As a small business owner, one of the key decisions you'll face is how to pay yourself. Should you take a draw or pay yourself a salary? When to start paying yourself on payroll? Both options have their pros and cons, and the best choice depends on your business structure, financial situation, and personal needs. In this article, we'll explore the different methods for compensating yourself and help you determine the best approach for your unique circumstances.

Understanding Your Business Structure

Before deciding how to pay yourself, it's crucial to understand your business structure. Your business entity type affects your options and the tax implications of your choice. Here are the common types of business structures:

Sole Proprietorship: This is the simplest business form where you and your business are considered the same entity.
Partnership: If you own a business with one or more partners, this structure applies.
Limited Liability Company (LLC): An LLC provides more flexibility and protection while allowing for a variety of tax treatments.
Corporation (C Corp and S Corp): Corporations are more complex, with C Corps subject to double taxation and S Corps allowing profits to pass through to owners to avoid double taxation.

Draw or Salary?

Taking an Owner's Draw

An owner's draw is when you take money from your business profits for personal use. It is common in sole proprietorships, partnerships, and LLCs. Here's what you need to know about taking an owner's draw:

Pros of an Owner's Draw

Flexibility: You can withdraw money as needed, without a fixed schedule.
Simplicity: Less paperwork and fewer formalities compared to paying a salary.
Tax Benefits: You only pay taxes on the profits of the business, not on the draw itself.

Cons of an Owner's Draw

Inconsistent Income: Without a regular paycheck, budgeting for personal expenses can be challenging.
Tax Complexity: You may need to make estimated tax payments throughout the year to avoid penalties.
Potential Cash Flow Issues: Taking large draws can impact your business's cash flow and financial health.

Paying Yourself a Salary

Paying yourself a salary involves setting a fixed amount of money to pay yourself regularly, like an employee. This method is common in S Corps and C Corps. Here's what you need to know about paying yourself a salary:

Pros of a Salary

Consistent Income: Regular paychecks make it easier to manage personal expenses and budgeting.
Tax Withholding: Taxes are automatically withheld from your paycheck, simplifying your tax obligations.
Professionalism: Paying yourself a salary can enhance the perception of your business's professionalism and stability.

Cons of a Salary

Administrative Burden: More paperwork and compliance requirements, including payroll taxes and filings.
Less Flexibility: Fixed payments may not align with your business's cash flow, especially during slow periods.
Potential Tax Implications: Salaries are subject to payroll taxes, which can increase your overall tax burden.

Factors to Consider to Start Paying Yourself on Payroll

Financial Health of Your Business

Your business's financial health plays a significant role in deciding how to pay yourself. If your business has steady and predictable income, paying a salary might be feasible. However, if your income fluctuates, an owner's draw might offer more flexibility.

Personal Financial Needs

Consider your personal financial needs and obligations. If you have regular expenses like mortgage payments, a consistent salary might provide more stability. On the other hand, if you can manage with irregular income, an owner's draw might be sufficient.

Tax Implications

Tax considerations are crucial when deciding between a draw and a salary. Consult with a tax professional to understand the tax implications of each method for your specific situation. They can help you navigate the complexities and ensure compliance with tax regulations.

Legal Requirements

Depending on your business structure, there may be legal requirements for compensating yourself. For example, S Corps are required to pay reasonable compensation to owners before taking distributions. Ensure you understand and comply with any legal obligations.

Steps to Pay Yourself

For an Owner's Draw

Determine Your Draw Amount: Calculate how much you need to cover your personal expenses while keeping enough in the business to cover operating costs.
Set Up a Separate Account: Keep your business and personal finances separate. Transfer funds from your business account to your personal account as needed.
Track Your Draws: Maintain accurate records of all draws for tax purposes and financial planning.

For a Salary

Determine Your Salary: Set a reasonable salary based on your role, industry standards, and business profits.
Set Up Payroll: Use payroll software or a payroll service to manage your salary payments and tax withholdings.
Pay Yourself Regularly: Issue regular paychecks, withhold taxes, and comply with payroll filing requirements.

When to Reevaluate Your Compensation Method

As your business grows and evolves, it's essential to reevaluate your compensation method periodically. Changes in your business structure, financial health, or personal needs may warrant a different approach. Regularly consult with financial and tax advisors to ensure your compensation strategy aligns with your current situation and goals.

Conclusion

Determining the method of compensation from your enterprise is a crucial choice that affects both your personal financial situation and your business's wellbeing. Whether you opt for an owner's draw, a wage, or a mix of the two, it's important to take into account your company's framework, financial stability, personal requirements, and tax consequences. By thoroughly assessing these elements and consulting with a professional, you can select the most suitable way to remunerate yourself and guarantee your business's enduring prosperity.

Remember, there's no one-size-fits-all answer. The best way to pay yourself will depend on your unique circumstances and goals. Remain knowledgeable, maintain adaptability, and make necessary modifications to bolster your personal financial health and the expansion of your business.