Business

Getting Paid: Salaries, Draws, and Distributions

June 24, 2021

Getting paid shouldn't be an afterthought for new business owners. Here is how business owners should get paid based on their company's structure.

Image of scattered one dollar bills.

Launching a New Business and Getting Paid

New business owners exist in an alternate universe during the first year of operation.  On one hand, they are riding the high of endless possibilities.  They are hopeful for what’s to come and clearly optimistic.  After all, it takes an optimist to muster enough belief in a dream to breathe life into it.  Furthermore, they feel confident that they know what to do to get paid.

On the other hand, new business owners are not immortal, so it’s only natural that a bit of worry may accompany the optimism.  Nothing is guaranteed, and a new business’s success during the first year is of utmost importance.  Ultimately, their success will be evident through their ability to pay their overhead and operating costs, and still pay themselves.

So, let’s review the different ways business owners can make sure they are getting paid.  After all, it would be a shame to start a cool new business that goes bottom-up because everyone makes money except the owner.

How to Get Paid

Determining how to get paid is not rocket science, and that’s a good thing since it takes so much effort to just launch a business.  Basically, getting paid is a three-step process.

3-Step Process

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As much as they might like to do it this way, business owners can’t just pull a number out of a hat and use it as their salary.  The IRS has certain guidelines that may seem loose on the surface but are meant to encourage business owners to avoid paying themselves amounts that are too high or too low. 

Before arriving at that final dollar amount, business owners need to do the following: 1) know what type of business they operate, 2) know how they should take their pay, and 3) analyze their company revenue and expenses.  In consecutive order, these three steps will help business owners get paid.

First Step: Determine Business Structure

For starters, business owners will need to know what kind of business they operate.  The most common types of business structures are as follows, along with their definitions according to the IRS:

  • Sole Proprietorship – A person who solely owns an unincorporated business. 
  • Partnership – Two or more people conducting business together. Each individual makes contributions (money, labor, etc.) and is responsible for their share of the business’s profits and losses. 
  • Limited Liability Corporation – A business structure permitted by statutory rule whose regulations are determined by the state.  Owners of LLCs are called members, and members can include individuals, corporations, other LLCs and foreign entities.
  • S Corporation – Corporations that choose to transfer corporate income, losses, deductions, and credits on to their shareholders for federal tax assessment.
  • C Corporation – A corporation that takes the same deductions as a sole proprietorship, but also takes special deductions.  The C Corp can be double taxed with no tax deduction when distributing dividends to shareholders.
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Once an owner determines the business structure, the next part is easy.

Second Step: Decide on Pay Type

Now, there are a few ways business owners can get paid as they are running their business.  The most common pay types are as follows:

  • Salary – Regular payment that is commonly received bi-weekly or monthly.
  • Draw – Taking funds from the company in the form of payment for personal use.
  • Guaranteed Payment – Payment to partners for services rendered.
  • Distribution Payment – Payment from a company to shareholders in the form of cash, stock, or products.

So, how do business owners know which type of pay they should be receiving?

  • Sole Proprietors take a draw.
  • Partners in a partnership take a guaranteed payment.
  • Owners of an LLC take a draw.
  • Owners of an S Corporation must take a reasonable salary.
  • Owners of an S Corporation take a salary and also receive distribution payments.

After deciding on pay type the fun stuff begins.

Third Step: Finalize Pay Amount

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At this point, business owners will need to be able to anticipate how much money their business will earn over the course of the next year.  Now, before they get too excited, they’ll want to estimate with caution.  In fact, it’s a good idea to use a P&L and a trusted accountant or financial adviser to help out.

A P&L is a profit and loss statement that accomplishes just what it says—to determine if a company is making or losing money in any particular area.  A company’s P&L starts with a company’s revenue, then subtracts overhead and operating expenses.  These items include rent, payroll, materials to produce goods, etc.

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Adjusting the salary, draw, or payment amount on the P&L will help determine how much business owners should pay themselves while still running a profitable business.  The P&L will show whether the business owner’s payment is reasonable within the big picture of the company.

Getting Everyone Paid

Starting a new business can be very fun and rewarding, but it can also carry risks.  Many great business owners have had uneasy moments when they didn’t know how they were going to pay their employees and themselves.  It’s not uncommon for business owners to temporarily sacrifice their own income to make sure employees get paid. While that may work in the short term it is not sustainable.  Business owners are not exempt from needing an income, especially if they aim to continue operating.

Before launching, it’s a wise idea for business owners to predetermine how they will pay themselves.  They can do this through a simple 3-step process.  First, they need to know their business type. Next, they need to decide on the appropriate pay type based on their business structure.  Finally, they need to analyze their anticipated finances to know how much they should pay themselves.

Going into the first year of operations with a solid plan for getting paid gives new businesses a better chance at thriving for the long term.

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