At the core of this question is the fundamental idea of how your compensation is viewed within the context of your business operations. When you receive a salary, you are being paid as a regular expense to the business to compensate you for your ongoing investment. Whereas a draw operates on the principle that as a business owner you can take some or all of what is left of the business’ equity after expenses are paid.
In the case of single-member companies, startups, and small businesses, equity can be a murky topic because it not only represents financial investments but also intellectual investments. In sole proprietorships and LLCs, it is often difficult to differentiate between the business and the individual, which is the reason business and personal finances need to be kept completely separate.
Determining which compensation option is the best fit requires a close examination of your business structure, short-term needs, and long-term objectives. Failure to align these crucial elements can cause financial instability and leave your business vulnerable in an audit.
Business Entity Considerations
The more sophisticated the entity, the less likely a business owner is to be compensated through a draw.
Owners of C corps are more likely to be paid salaries because otherwise profits are taken as dividends, which are double taxed. In this instance, there is a substantial incentive to reduce tax burden by increasing expenses using salaries. Furthermore, S Corp owners must be paid a salary.
However, disregarded entities like single member LLCs and sole proprietorships have more flexibility with compensation. Similarly, multi-member LLCs and partnerships do not follow a strict compensation formula. For these business entities, more questions need to be answered before deciding on whether to take compensation in the form of a salary or draw.
Keeping Clean Books
Knowing who will view your books is an essential component to consider when deciding between paying a salary versus taking a draw.
With serial entrepreneurs the focus is on starting businesses frequently with the purpose of building and selling them quickly. In this business model, prospective buyers will require a thorough analysis of business financials before signing off on a deal. For this reason, keeping clean books is of the utmost importance.
The same is true of businesses that will have their financials reviewed by banks, venture capitalists, or other funding sources. Being accountable to partners or third-party institutions requires a commitment to keeping clean books, especially around owner equity and compensation.
While this does not definitively answer the question of whether an owner should be paid a salary versus a draw, it is far more conducive to the salary model. However, business owners that keep meticulous records can still maintain clean books using the draw method for compensation.
Short-Term Business Needs & Long-Term Goals
Business planning is a crucial component of determining compensation structure because salary payments and withdrawals tie-up capital that could otherwise be reinvested in the company.
When positive cash flow is needed for immediate investments in things like equipment, paying a routine salary can tie up critical capital. The result is stymied business growth due to cash usage restrictions, which can, in turn, hurt future abilities to pay owners and employees, potentially causing a business death spiral.
The same holds true for draws that are too large. Owners that pay sizeable draws infrequently can result in a profitable business being cash poor as well. Therefore, while a draw tends to favor business growth, the most critical consideration is the size of the payout, not the type of payout.
In instances where paying expenses in a timely manner reduces the overall cost of acquiring or using assets, owner draws can leave free capital to cover expenses while also compensating owners, when available. However, the result is often a below-market pay rate for owners, which is not a permanently sustainable solution.
Businesses that have long-term growth objectives can benefit from the predictability of recording a salary expense. This is an especially salient distinction for businesses that are intended as long-term ventures, like family-managed businesses that are expected to be passed on to future generations.
Personal Tax Planning
While business owners can receive the same compensation amounts across draws and salaries, taking a draw requires more personal tax planning. Salaried compensation automatically deducts tax withholdings and benefits payments to make owners’ daily operations easier. However, a draw is a simple lump payment, which means that owners need to calculate their own tax burden and benefits costs. While many business owners do this effectively on their own, it adds an extra layer of complexity that some owners prefer to forego.
Business structure, cash flow, long term goals, and convenience are key considerations when determining whether a salary or draw is more appropriate for a business owner. Regardless of the way they are compensated, keeping accurate records gives owners additional peace of mind. If you have any questions about how to set up your books to ensure the benefits and lower the risk, please contact us here.
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