Congratulations! Your small business has moved beyond the initial startup phase and is now a profitable venture. Although you may have worked for free in the early days, it’s time to pay yourself for your efforts.
You generally have two options for taking home a paycheck: a salary and/or a draw based on the structure of your business.
If you are an officer in a corporation, the law says you must be on the payroll and receive regular checks that include withholdings for Social Security, Medicare, federal income taxes, and state income taxes in states that require them.
If your company is legally structured as an S Corporation, you must receive regular paychecks with those same withholdings, but you also have the option of taking additional money beyond your salary in the form of a draw or distribution. Checks for draws and distributions are written without withholding the taxes that are taken out of a regular payroll check.
So, how do you decide how much to take as a salary and how much to take as a draw?
As far as your salary goes, the IRS requires you to earn reasonable compensation for the type of work that you’re doing. As a guideline, the government suggests choosing an amount similar to what another business would pay someone to do what you do.
Sheryl Schuff, a CPA who specializes in small-business bookkeeping and payroll, says that before you start cutting checks to yourself, you need to carefully consider the total amount of your salary and draws.
“Owners of S Corporations have come under increased scrutiny the past several years, as they typically prefer to take draws rather than payroll to avoid paying the associated payroll taxes,” Schuff says. “It’s imperative for business owners to understand the position the IRS takes on reasonable compensation. One of the largest financial risks to entrepreneurs is penalties and interest for incorrect payroll-tax reporting.”
Sole Proprietors and Partners
Sole proprietors and members of partnerships are free to pay themselves — or otherwise take the profits out of their businesses — whenever they’d like. Payroll withholdings do not apply, but each individual essentially pays the equivalent on his or her reported income at tax time.
For better financial organization, small-business owners who are sole proprietors or partners should consider paying themselves some kind of salary on a regular basis. A regularly scheduled payment from the business account to the owner helps to establish a clearer picture of what the company costs to run.
When paying yourself a draw, you must consider the eventual tax bill. You can implement a system as simple as keeping the cash to pay taxes in an envelope for later, writing monthly checks to the IRS, or making quarterly estimated tax payments.
It’s a big milestone when a business becomes profitable enough that you can be paid for your efforts. Deciding how much to pay yourself, and whether to take the money as a salary or as a draw, requires careful consideration.
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An associate and I had the opportunity to interview a larger accounting firm this week. They shall remain unnamed to protect their brand integrity but what we found was a little appalling. Have you ever met someone in business that protects themselves so well it passes the point of protection and moves into aggression? This firm has designed an offering to their potential "Franchisee" candidates that virtually eliminates the possibility of success. This may sound naive on my part but hear me out.
They offered us an "opportunity" to own one of their franchises. We will always entertain a good opportunity so we agreed to meet with them and discuss details. What they said to us in person sounded OK so we asked to see it in writing (Step 1. Always get everything in writing). Once we had a chance to examine the agreement docs we were shocked! Upon much closer inspection, the agreement automatically rebuked itself within 6 months if the revenues were not going to top 1M within a first year projection. Aggressive... yes. Impossible... no. We go on.
They require you to take a minimum salary from your company even if your company cannot cover the salary. The difference is then rolled into a Series B loan payable interest free to the parent company. Historical track record sets them at about a 6% net which is then split 75% parent company and 25% Franchisee. Pretend you did create revenues of $1,000,000 in year one, your net profit is $60,000 and your minimum salary is $125,000 you will end up with a cash debt loan of $65,000. Your distribution is $15,000 and will take more than 4 years to pay back. That loan tops out at $50,000 then your salary option disappears until the salary loan is paid back in full. Your incentive wanes because now you can no longer collect a salary until the loan balance is paid, and you only have claim on $15,000 per year worth of equity disbursements. The harder you work, the further in debt you fall.
I closed the proposal at this point and suggested we use it as fire starter this winter but we continued to review the agreement. Next we found the voting and ownership rights of the company belong 100% to the franchisor and his flexibility, growth, strategy, etc. is given by corporate mandate. We report numbers and discuss metrics on a weekly basis with corporate but our 25% ownership is Series B and not series A. Only Series A has voting and decision rights for the franchise. Furthermore if we could not accomplish the goals within 6 months (which we have demonstrated cannot happen) there was automatic termination of the agreement with the full loan amount due and payable immediately.
So let's summarize. You work for 6 months, rack up $60,000 debt to pay back all of the "salary" you had received, AND you leave your $60,000 monthly billings under their company of which you have no say. You are booted out the door and corporate takes over your office and your billings.
Well... amen to that agreement. Amen to the "opportunity" and amen to my rant on protection vs aggression with franchise agreements.
Guys! Don't sign it without consulting a professional first. Have your CPA or attorney review the documents and run the numbers so that you have a clear picture of the offer. Your professional is worth double whatever he charges you because his professional opinion may save you hundreds of thousands of dollars in the end.