Salary or Drawings: Why Must I Pay Myself Salary as a Business Owner?

 

Salary vs Drawings: The million dollar decision every business owner must make

Photo by Andrea Piacquadio

As a business owner, should you pay yourself a salary or take drawings? One of the most crucial decisions you'll face is how to compensate yourself. This choice can have significant implications for both your personal finances and your business's health. In this article, we'll explore the factors to consider when deciding between salary and drawings, and provide guidance on when each option might be most appropriate.

Understanding Salary vs. Drawings

A salary is a regular, fixed payment to an employee, often paid on a fortnight or monthly. As a business owner, paying yourself a salary means you're treating yourself as an employee of your company. In South Africa, if you're a director of a business, you must register with the Unemployment Insurance Fund (UIF) and for Pay As You Earn (PAYE), if you're taking a salary.

Drawings, on the other hand, are when the owner takes money out of the business to pay themselves, These are not considered a business expense and are typically used in sole proprietorships and partnerships. If you have a side hustle with irregular income, such as freelance work where clients pay at different times, you might choose to take drawings from your business instead of a fixed salary.

Factors to Consider When Choosing Between Salary and Drawings:

Business Structure

The legal structure of your business plays a significant role in determining whether you should take a salary or drawings. For instance, if you're a sole proprietor or in a partnership, you're more likely to take drawings. Sole proprietors are people who run businesses that are not registered; freelancers, people with rental income, and any other person who makes an extra income separate from their salaries are seen as sole proprietors.

However, if you have a registered business, you may be required to take a salary.

Tax Implications

The tax consequences of salary versus drawings can be substantial. You pay UIF and PAYE when you take a salary, but not when you take drawings.

However, drawings may be subject to income taxes, depending on how much money you've made. Remember, when you have a side hustle, you're being taxed as an individual. You can reduce the taxable income by keeping records of all your income and expenses. Your income tax liability will be reduced by allowable deductions. However, SARS may need proof of these expenses, like invoices

As a sole proprietor, you are also responsible for registering your employees and complying with employer tax obligations, including UIF and PAYE, just like any other business owner. While you may not be taking a salary, you still have a responsibility towards your employees.

Business owners who do pay themselves a salary, and have registered for UIF and PAYE, must submit and pay these returns monthly. If you skip even one month, the South African Revenue Service will charge penalties and interest.

Submitting employer taxes is an administrative burden and must be done by a professional.

It's crucial to consult with an accountant, bookkeeper or a tax professional to understand the full implications for your specific situation.

Financial Stability of the Business

The financial health of your business should be a key consideration. If your business is in its early stages or experiencing cash flow issues, drawings might be more appropriate as they offer more flexibility.

For many business owners, it is almost impossible to take a salary when they start their companies. But even if they take drawings, they must still be disciplined about managing the money.

The most important thing to remember, is to separate your business and personal finances. This can be done by having separate bank accounts for your business and personal expenses, and not to mix the two. All business income should be deposited into your business account, and business expenses should be paid from this account.

The quickest way to a financial mess in your business is to mix your business and personal finances.

Personal Financial Needs

Your personal financial situation also plays a role. Many entrepreneurs rely solely on their business income to support themselves and their families; often even extended family depend on this money.

If you are the breadwinner for many family members, it can take a financial and emotional toll, and it might be much more difficult to manage your finances. The most difficult part would be to limit the amounts of money you draw from the business. It would take immense discipline and self control to take enough money to support yourself and your family, while building a solid financial foundation.

It's essential to consider your personal financial needs when deciding on the amount of drawings to take from your business.

If you need a steady, predictable income to cover your living expenses, a salary might be the better option. Provided you are the owner of a registered business.

When to Take a Salary

If you rely on a consistent income to meet your personal financial obligations, taking a salary can provide that stability. This is particularly important if you have regular expenses like bond payments or loan repayments.

A regular salary can help you build a good credit history., which can be beneficial when applying for personal loans or bonds. Lenders often prefer to see a steady income stream.

When you apply for any financing, lenders only need your pay slip, bank statements and a list of your expenses. The application process is less admin intensive for a salary earner because the pay slip serves as proof of income, and your bank statements show your expenses.

When to Take Drawings

If your personal financial needs are fluctuating or if you're comfortable with an inconsistent income, drawings can offer more flexibility. You can take more when the business is doing well and less when it's not.

In some cases, taking drawings instead of a salary can result in lower overall taxes. This is particularly true for sole proprietorships and partnerships, where the business income taxed on the same scale as personal income.

If your business has irregular cash flow or is in its early stages, drawings can be more appropriate. You can adjust your withdrawals based on the business's current financial situation without committing to a fixed salary. Just remember, that you will still be taxed afterwards, if you above a certain threshold.

Hybrid Approach: Combining Salary and Drawings

Many business owners find that a combination of salary and drawings works best. This method enables you to reap the advantages of both techniques.

You could take a modest salary to cover your basic living expenses, while also taking drawings when the business performs well.

But pay yourself a reasonable salary. The South African Revenue Service might increase your taxes if the salary that you pay is too little compared to what you made during the year. If your profits are R500 000, paying yourself a salary of R5 000 is not going to cut it.

The key is to set a comfortable salary that, even with UIF and PAYE deductions, you can afford to pay yourself monthly.

Legal and Regulatory Considerations

It's important to note that there are legal and regulatory considerations when deciding between salary and drawings. For instance, if you're running a registered business, you're required to take a reasonable salary. Failing to do so could result in SARS penalising your company.

Impact on Business Valuation

Your compensation method can affect your business's valuation. A business that pays its owner a salary may be valued differently than one where the owner takes drawings. This is something to consider if you're planning to sell your business in the future.

Regardless of whether you choose salary, drawings, or a combination of both, it's crucial to plan for the future. This includes setting aside money for retirement, considering succession planning, and ensuring that your compensation strategy aligns with your long-term business goals.

Conclusion

The decision between taking a salary and taking drawings as a business owner is complex and depends on various factors including your business structure, personal financial needs, and long-term goals. While salaries offer stability and can be beneficial for credit purposes, drawings provide flexibility and potential tax advantages. Many business owners find that a hybrid approach works best.

Regardless of your choice, it's crucial to consult with financial and legal professionals to ensure your decision aligns with regulations and optimises your personal and business financial health.

If you have any questions on how to pay yourself, don't hesitate to give us a call.

FAQs

1. Can I switch between salary and drawings?
   Yes, you can generally switch between salary and drawings, but it's important to consider the tax implications and ensure you're complying with any relevant regulations.

2. How do drawings affect my personal tax return?
   Drawings are not considered income for tax purposes when taken, but the profits of the business (which include any drawings) will be reported on your personal tax return if you're a sole proprietor or partner.

3. Is it possible to take both a salary and drawings?
   Yes, many business owners opt for a hybrid approach, taking a modest salary and supplementing it with drawings as needed.

4. How does taking a salary impact my ability to get a loan?
   Taking a regular salary can improve your chances of getting a personal loan as it demonstrates a steady income to lenders.

5. Are there any legal requirements for how much salary I should pay myself?
   If you're operating as a corporation, SARS requires that you pay yourself a "reasonable" salary. What's considered reasonable can vary, so it's best to consult with a tax professional.