Congratulations! Your small business is turning a profit, and you’re finally able to withdraw some money for yourself. Before you head to the bank, you should know that taking cash out of your business can be complicated, and has certain tax implications. But don’t worry—in this article we’re breaking it all down so you can pay yourself with confidence.
Read on to find out:
- How much you should pay yourself
- The best way to withdraw money
- Tax implications to be aware of
- And other important details about paying yourself from your small business
Does the Type of Business I Run Affect How I Can Pay Myself?
Most types of businesses, specifically sole proprietorships, partnerships, and limited liability companies (LLCs) have fairly straightforward rules. If you have a separate business bank account (which you will need if you’re an LLC and may have if you’re a partnership), you pay yourself by transferring money from your business bank account to your personal bank account.
If you’re running a business as a sole proprietor, you might just have one account that combines your personal and business transactions. In that case, you don’t need to transfer money at all. Regardless of whether you physically transfer money, you will normally show any payments as “drawings” in your bookkeeping system. Drawings represent any money that you choose to pay yourself.
In most cases, your business does not pay taxes itself. Instead, earnings from your business— including money you pay yourself—“passes-through” to the personal tax returns (1040s) of the owners, and that is where it will be taxed.
Do I Pay Employees in the Same Way?
If you have employees, you will need to pay them through a payroll system. You enter their payments, run payroll, and transfer their salary (less taxes), to their bank accounts. You typically do not need to have a payroll system if you’re running a sole proprietorship, partnership, or LLC and you’re only paying owners.
Are There Other Ways of Paying Myself Besides Drawings?
If you own an S-Corporation, a C-Corporation, or you’re an LLC that chooses to be taxed as an S-Corporation, you will need to pay yourself through a payroll system. In some cases, there may be tax advantages for doing this, but it’s a complicated area, so we recommend speaking to your accountant.
How Much Should I Pay Myself as a Small Business Owner?
There’s no hard and fast rule on how much or how little you pay yourself and other owners. But rather than taking a shot in the dark, here are some steps we recommend taking to figure out the best approach for your small business:
- Calculate the total revenue your business makes in one month—this is all of the money your business earns, including products and services sold, investments, and other means.
- Deduct the total of all your actual, upcoming, and likely business expenses in a month. These expenses might include utility bills, computer software and hardware, equipment rental, loan repayments, depreciation, marketing, property costs, or any of dozens of other expenses.
- Deduct the amount of money used to buy inventory or provide services—this is the money you spend that allows your business to operate and make money.
- The total remaining are your business profits, and it’s these profits that you will use to work out how much you can pay yourself.
- Before taking money out of the business, you should ensure you have enough cash left in the business as a buffer against hard times, and that you can reinvest to expand into other markets.
- We recommend a cash buffer that will cover at least three months of operational expenses.
- Once you’ve taken account of your cash buffer and money for reinvestment, you can pay yourself out of the remainder.
Does How Much I Pay Myself Impact the Amount of Tax I Pay?
Not really. In most cases, you will be taxed on the profits your business makes, rather than how much you physically take out of the business. For example, if your business has $150,000 a year in income and expenses of $50,000, your profits are $100,000, and you may withdraw $80,000 to your personal bank account.
You will pay taxes on the $100,000 of profit, not on the $80,000 you actually transferred. The IRS and your state’s Department of Revenue will tax you on your overall profits and business earnings (revenue less expenses) not on how much you take out. This can change if you’re paying yourself through a payroll system or as an S or C Corporation—in those cases, talk to your accountant.
What Types of Tax Will I Need to Pay on My Business Profits?
Taxes are levied by the Internal Revenue Service and by your state’s Department of Revenue. These taxes are:
- Federal income tax is levied on the profits of your business and paid to the IRS. This tax is charged in bands depending on your level of income. Payrolled employees will pay this through your payroll system, whereas owner profits and drawings will be taxed on your individual 1040 tax return.
- Self-employment tax (Social Security and Medicare) is levied on the profits of your business and paid to the IRS. It is charged at a flat rate of 15.3 percent.
- Payroll tax is levied on salaries paid to employees through a payroll system, at a rate of 7.65 percent to the business and 7.65 percent to the employee. If you’re an owner, you won’t typically be on payroll, but if you are, you only pay payroll tax or self-employment tax, not both.
- State tax is levied by your state DOR depending on your business profits. Some states do not charge state income tax.
How Much Should I Put Aside for Taxes on What I Pay Myself?
Your accountant can advise you on exactly how much tax you will owe, but a good rule of thumb is to set aside 30% of your earnings to pay as tax.
Do I Need to Pay Estimated Taxes on My Projected Business Profits?
If you’re not on payroll (i.e. you’re paying yourself through owner drawings), you will need to pay estimated taxes to the IRS and your state. These estimated taxes are due four times a year, normally by the 15th of April, June, September, and January. You should calculate how much profit your business is likely to earn a year and how much the taxes would be on that amount. You’ll then pay a quarter of that in each estimated tax payment.
How Can I Reduce the Amount of Tax on How Much I Pay Myself?
Your accountant can advise you on ways to lower your tax bill, but one of the best ways is through making retirement contributions. If you create a 401(K) for your small business, you can make payments into the “traditional” part of your retirement plan and you won’t be charged tax until you take the money out at retirement.
What Should I Do Next?
Everyone’s business circumstances are different. You should always speak to a qualified accountant to understand your options for paying yourself, your tax liabilities, financial management, and how to reduce your taxes.