One question that all business owners face is how much they should pay themselves. It's especially important for small business owners during their first few years in operation.
There are several considerations that come into play when choosing how much money to withdraw from your business. This article addresses some of them, but keep in mind that every business is different. How you apply these guidelines should be based on your specific business model and the goals that you've set.
The natural tendency is to scrape by while you build your business, assuming that you'll reap the benefits of your sacrifice in the long run. If that sounds like you, you're not alone. If you underpay or don't pay yourself, this could have a very detrimental effect on your life away from the business. That, in turn, will take its toll on your ability to run and grow the business, both financially and psychologically.
Unless you have a separate income or savings to sustain yourself, you'll have to draw enough from your business to live on, even if this causes your business to lose money. You can't sustain that forever, so scrub your sales and cash flow projections and figure out a way to reach profitability as soon as possible. You deserve a salary for what you do and should make a reasonable return on what you own.
How you set up your company as a legal entity will influence how you structure your compensation plan. A key consideration is how your business will be taxed, and there are two general categories: corporations that are taxed at the corporate level, and pass-through businesses that are taxed at the individual shareholder level. Those taxed at the corporate level include corporations, limited liability companies taxed as corporations, and non-profit organizations. Those taxed at the owner level include sole proprietorships, partnerships, S-corporations, and limited liability companies taxed as partnerships.
The net profits generated by sole proprietors and partners are taxed as if they were ordinary income. You prepare one tax return and attach the appropriate schedules for your particular business. Corporations accrue profits at the corporate level and pay salaries as a cost of doing business. Corporations must also fi le a tax return that is separate from your individual return. If your corporation is paying you as an employee, then you report that income on your return.
Among the advantages of incorporating are the flexibility to minimize your tax liability by deferring compensation, staggering bonuses, zeroing out the company's income, using a special fiscal year, and awarding stock options. The detailed tax implications of employing these techniques are far too complex to be adequately covered in this article, and require the expert guidance of a tax attorney or accountant. They will help you avoiddoing anything that will set off flags to the IRS.
Also keep in mind that you have the option to change the form of your business as it grows and your needs change. This provides some flexibility to control risk and tax liabilities, and enables you to reinvest in the business in the most cost-effective manner.
There are two prevailing theories for paying yourself during the early years: (1) Just enough to get by; and (2) What you're worth.
Getting by allows you to invest more resources directly back into the business. If you pay yourself first and turn around and put some of that money into the business, you'll pay taxes on it unnecessarily. The theory behind going lean at the beginning is based on reducing your expenses so that you can use available capital to expand the business as fast as possible. Once the business is established and operating in the black, then you increase your salary. The downside of this approach is that it creates an artificial picture of what it takes to operate at a profit and support yourself.
The more realistic approach is to pay yourself what you're worth, even if it means showing a loss for the business. This would be included in your business plan as an expected expense for financing purposes. If you're counting on a bank loan to get your business off the ground, the loan officer will thoroughly review the credibility of your sales and expense projections. They expect a return on their investment, so their confidence in your estimates is crucial. Paying yourself a fare wage offers the consistency of knowing that operating costs will be stable regardless of current business conditions.
If you decide to pay yourself just enough to meet basic living requirements, you've already got all the data needed. Prepare a personal financial statement that lists your monthly expenses: mortgage/ rent, food, utilities, insurance, transportation, taxes, debt payments, and other miscellaneous expenses. Add a line item for contingencies and discretionary items to give yourself a cushion to fall back on. Unless you have a capital reserve that you can dip into, the sum of these expenses is the minimum you should pay yourself in the beginning.
Deciding what you're worth is subjective, but a starting point is your value on the open market. However, many people go into business because they believe they're worth more than they've earned in the past. They want financial security for themselves and their families, so their salary target will be some amount above the market. If you're going to put forth the effort and assume the risk of running your own business, you deserve to be rewarded accordingly.
There are general rules of thumb on what you should make beyond the market, but they're simply guidelines, not constraints. Put yourself 20-30% above what you would expect to make in a comparable job working for someone else in the same type of industry in your location. If you're not clearing enough to pay that much now, put it in your plan anyway. You'll find it hard to meet your goal if you don't seriously aim for it, and you can always adjust it later.
Some business owners get so immersed in their business that they lose sight of the big picture. Since undercapitalization is the number one cause of business failures, cutting your own pay to the bone won't solve that problem. Your livelihood is at stake, so make sure you're taking care of yourself and your family. If your business doesn't make it and you haven't paid yourself anything, you'll have put yourself in a very difficult financial dilemma.
If you're successful and your business is growing and turning a profit, increase your pay at least as much as
that growth rate. Analyze your other expenses to ensure that this won't impact your bottom line and sales goals. If you can maintain a sales growth rate that exceeds the rate of increase in expenses, you should be able to adjust your pay accordingly.