How Small Business Owners Should Pay Themselves
When you’re the boss at a small business, it’s up to you to decide your employees’ wages and compensation — including your own. It’s a unique position to be in as an entrepreneur — deciding if, when and how to pay yourself, especially when the business is just starting out. If you don’t take care of your accounting, you may end up falling behind on your personal obligations, or worse, on the business.
What to pay yourself when your business is just starting out depends on a variety of factors. For example: Are you the only employee? How much capital do you have to start the business? How quickly will you reach breakeven?
There are those considerations and a host of other miscellaneous factors, depending on your business and lifestyle that may make figuring out your salary more complicated than you imagine.
In this article, we will cover:
Generally speaking, there are two methods you can use to pay yourself as a business owner. You could pay yourself a traditional salary, like a standard company employee, or take an owner’s draw from your profits. Depending on how your business is structured, you may not have a choice in taking a traditional salary.
If you take an owner’s draw, you periodically withdraw an amount from the company’s profits as your compensation. So, essentially, you live off of your business’s profit. Owners of sole proprietors and partnerships should use the owner’s draw, according to Atlanta-based certified financial planner, Lane Mullinax, JD, MBA. He emphasizes taking a salary as a sole proprietor or partnership is not correct and may raise tax issues eventually for a self-employed person.
You can calculate your draw amount using profit you’ve already made, capital already invested in the business or what you expect to make for the period. Be careful to withdraw from the profits, not the revenue. If you are corporate officer in an S-corporation you will be required to take a salary, but you can also take a draw. You may not, however, take an owner’s draw from a C-corporation.
Pros of an owner’s draw:
- Taxes deferred. When you take an owner’s draw, you won’t see employment taxes like Medicare, Social Security or income taxes withheld at the time of the draw as you would on a pay stub because the draw isn’t taxable at all, says Mullinax. But, remember, you will have to report the income and pay self-employment taxes on the money when you file your annual taxes. To ease your tax burden at year’s end, you can set the amount you would be taxed aside in a separate account or pay estimated taxes quarterly during the year and make up for any difference at tax time.
- Pay yourself whenever you want. You can take from your business profits whenever you’d like if you’re taking a draw, Morristown, N.J.-based certified financial planner Bernard M. Kiely, CPA, tells LendingTree. This can come in handy because you can time your draws to your needs or take an unplanned draw if necessary. But, for better organization and simplicity during tax time, you should try to keep yourself on a regular schedule.
- Doesn’t have to be the same each time. You can take what you need, when you need it if you’re taking a draw. If you have some unexpected personal expenses one month, for example, and the company’s doing well, you can take what you need to cover the extra costs that month. Conversely, if profits are down, you can take a pay cut to prioritize revenue over your own personal profit.
- Must stay organized. To keep your records straight and avoid an IRS audit, tax experts agree it’s best to take your draws periodically — pay yourself the same amount every month or every two weeks, for example — and keep good records of your draws.
- Set aside taxes — When you take a draw, you should make sure you set aside money to pay off BOTH the employer and the employees’ shares of the self-employment taxes you’ll owe at the end of the year, says Kiely.
- Keep a separate account — The IRS recommends sole proprietors and partners in a partnership put the money they take from the business in a draw account so they know the amounts they have taken from the business during the year.
If you take a traditional salary, you’ll get a regular paycheck as you would with any other employer, except the business on the check is your own. The IRS considers partners in corporations (like S-corporation) employees subject to employment taxes, so if you are a partner, you’ll need to be on the payroll.
- Taxes already taken. When you take a salary, you don’t have to set aside money to pay off the employees’ portion of the self-employment taxes you’ll owe at the end of the year, because it’s taken from your paycheck. But, the company will have to pay its portion of employment taxes and gets to deduct that from its income at tax time.
- Paid regularly. You’ll be paid a salary regularly, so you’ll know when to expect your paycheck whether you’re paid weekly, biweekly, monthly or bi-monthly. If you’re paid a traditional salary, you should receive equal payments each time, which may make it easier to plan your personal budget.
- Can still take a draw. Even if you give yourself a salary, you can take a draw from the profits if you are a partner in an S-corp. Some business owners pay themselves a base salary, then take a draw each quarter after seeing the business profits, says P. Simon Mahler, a certified business mentor for SCORE, a national nonprofit that connects small businesses with mentors.
- Must stay “reasonable.” The IRS has this reasonable compensation rule. It requires you pay yourself a “reasonable wage.” The IRS says “wages paid to you as an officer of a corporation should generally be commensurate with your duties.” You can’t pay yourself $0 either. The tax rules require working shareholders to receive a salary so that they pay their Social Security and Medicare taxes. If you don’t pay yourself enough, the IRS may determine adjustments be made to the income and expenses for both your business and personal tax returns.
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As a sole proprietor, you are the only owner of the business. In this case, you would take a draw as payment. Sole proprietors can take periodic draws like a salary, but should not pay themselves a traditional (W-2) salary in addition to taking a draw, according to Mullinax, because it could lead to tax complications down the road.
“You can get away with it for a while if you are really simple and clean, and there is nothing else going on with your taxes but in my 30 years of experience, it will eventually lead to other issues,” says Mullinax.
Because you are able to deduct the company’s portion of employment tax as business expenses and reduce the business’s overall taxable income, you may pay less than you owe in taxes, Mullinax tells LendingTree. If you do that accidentally, it can raise a flag to the IRS to see what else you are doing wrong and open you up to an audit.
Paying yourself a traditional salary as a sole proprietor or partnership also creates unnecessary administrative overhead, says Mullinax, because the company’s income or loss is directly passed through to the owner’s tax return and taxed at the owner’s personal tax rate. So you will eventually pay both the employer and the employee portion of employment tax. If you are paying yourself a salary that’s reasonable, then you are likely going to be paying the same tax either way. Sole proprietors report business income or loss on a Schedule C (Form 1040).
If there are two or more people in ownership, the business is considered a partnership. Like the owner of a sole proprietorship, partners are not considered employees either and would not pay themselves a traditional (W-2) salary in addition to taking a draw. Partners must report their income from the company via Form 1065.
The LLC, or limited liability company, is a special case as it allows you to take advantage of the benefits of a corporation and a partnership. LLCs protect owners from personal liability in the event the business is unable to cover its debts.
When you form an LLC, you can elect to be taxed as either a sole proprietor (a single-member LLC), a partnership or an S-corp. Owners of single-member LLCs and those taxed as partnerships would not receive a salary in addition to a draw.
If the LLC is taxed as an S-corp, its owners must receive a salary. In addition, owners may draw from the company’s profits. The proportional amount of the LLC’s income or losses are still passed through directly to the owner’s personal income, regardless of tax election.
C corp (traditional salary required) — A corporation, called a C-corp, is a legal entity separate from its owners. The entity can be held legally accountable for its debts.
According to the IRS, an officer of a corporation is considered an employee. But, if you don’t perform any services or only minor services and don’t receive any pay, you are not considered an employee. As an employee, you are required to receive a traditional salary. The IRS requires the salary to ensure owners pay their share of employment taxes.
The corporation’s profit is taxed at the corporate tax rate when earned, then shareholders are taxed when the profit is distributed as dividends.
S corp (traditional salary required) — An S corporation, or S-corp, avoids the second level of taxation as the business profit or loss is proportionally passed through to the owners and taxed at the individual’s tax rate.
Officers of an S-corporation are required to take a salary as they are considered employees. In addition, owners may take a draw from the company’s profits. Your wages will be reported on a W-2 at year’s end. If you take a salary, your compensation must be considered a reasonable amount by the IRS.
It may be tempting to cut yourself a substantial paycheck, especially after years spent putting your livelihood on the line to launch a business. But when it comes to deciding how much you should pay yourself, the main factor an entrepreneur should consider is practicality, says Mahler.
“We all have expenses in life, says Mahler. “You have to realize that what you take for yourself as a salary takes from the business.”
To decide practically, you should also make sure to consider other owners, any employees you plan to hire and when you expect the business to break even.
Hunter Stunzi, president of SnapCap, a small business lender and LendingTree subsidiary, recommends taking little or no compensation if you are a majority owner in the business and plan to lose money for a period of time. That’s why it’s wise to build up a healthy savings fund before you launch a business, enough to cover your essential expenses for an extended period of time.
Sometimes an owner may be offered capital in exchange for equity. Stunzi says if you can avoid giving up equity for funding, you should. Meaning, if you can take a pay cut to a lower salary for now to preserve equity and keep your business running, you should opt for that instead.
“It’s always better to preserve your ownership (equity) initially and take a lower base then to be forced to sell ownership to fund the business later; equity should be preserved at all costs,” said Stunzi.
If you choose to take a draw or salary, here are a few options you can use to calculate how much you should pay yourself.
Pay yourself at least the minimum amount of money you need to cover your basic expenses. This is the approach Mahler recommends for the bootstrapping entrepreneur. To do this you would:
- Take into account all of your annual expenses. Take care to include all of your obligations in your budget.
- Divide that amount by 12 to determine the salary you’d need to cover your living expenses.
*Remember to include any side income or your savings in your calculation if you have money saved and plan to use some portion of it to live on while you bootstrap your company.
- Take only the amount you’d need to make up your “enough to get by” salary.
Mahler says this approach should give entrepreneurs a good indication of how they should prepare regardless of whether they are working at a job while trying to start a different business or if they go “all in” from the start.
Pay yourself just a little more than your current market value, to compensate for the responsibilities you’re taking on while running a business. To calculate your “basic worth:”
- First, take your current annual salary or hourly wage (annual estimate).
- Increase the amount by a percentage based on three to four times the rate of inflation.
The equation is: BW = MW * [1+(I*4)]
For example: Let’s say you are currently paid a $40,000 salary. The rate of inflation at the time of this writing is 2.1 percent. So the equation would look like BW = $40,000*[1+(0.084)].
Your basic worth annual salary would be $43,360.
Pay yourself a comparable salary to the leaders of companies similar to your venture. If you run a cloud storage company and the average compensation for CEOs for similar companies in your area is $150,000, you would pay yourself that equivalent.
You can check for comparable salaries with trade associations, online with websites like PayScale or Glassdoor or ask your local Small Business Development Center. If you’re involved in your local startup community, you may want to consider asking other entrepreneurs in your industry, too.
Give yourself what you deserve based on your experience and skills. This is what you would be paid by an employer in the current market. The amount does not have to equal what you were last paid by your previous employer, but this salary also does not factor in the time you put into the startup — only what you are worth based on your skills.
If you look on Glassdoor and find you are worth around $50,000 based on your skillset alone, you’d pay yourself that salary.
If you’re using the open market value method, you would pay yourself the open market rate based on your abilities, even if you were paid more by your previous employer.
“Salary + quarterly bonus”
Pay yourself a base amount that’s just enough to cover your expenses. Then, draw a bonus each quarter that corresponds to the company’s profit. This is the method Stunzi recommends entrepreneurs use. You may not take a bonus the first quarter and decide to reinvest the profit, but you may decide to take a $4,000 bonus if the company has a stellar quarter.
“I usually pay myself what covers all my bills plus a little extra, not much at all if the business can afford it. If the business cannot afford it, then I don’t take anything extra,” said Mahler. He tells LendingTree he took a $1500 to $4000 quarterly bonus when the business was doing well.
“I set the metrics and defined what it looked like for the business to do well, and if I did not achieve my outrageous goals, then no bonus was given,” added Mahler.
As a rule of thumb for smaller companies, Stunzi recommends you pay yourself no more than 70% of gross income. For example, If you will generate a gross revenue of $100,000 and operating costs are $50,000, you’d pay yourself no more than 70% of gross income, or $35,000.
Even if you get a hefty amount of startup capital and don’t need to restrict yourself to a salary that only covers your basic expenses, you may want to take a modest, reasonable salary.
“For the entrepreneur in areas where investment capital is possible, I see entrepreneurs go with $50,000 salaries and run with it,” said Mahler, who adds the amount is very reasonable if you are going to seek any type of funding.
For reference, the median personal income in the U.S. was $31,099 in 2016.
Pay yourself a small amount to start, but increase your salary as the company grows.
“Try and pay yourself from the start, but in low increments, and work your way up as time goes on. Getting your paycheck keeps you motivated to keep going and growing,” said Mahler.
Growth costs, too. If your company is rapidly growing, you may want to hold on to any “extra” cash in case you need to fund a project. In that case, you might not want to take a draw in addition to a base salary, or a larger salary than you need to cover your basic needs. As the company earns more profit, you can give yourself raises, accordingly.
At this point you may be wondering: “Okay, that’s all good info, but when do I get to start paying myself?” Again, it’s up to you and what your goals are. It’s okay to pay yourself starting out, if you aren’t seeking funding and your business can afford it.
“It is the lifeline for a small business to have all the dollars and support it can get when it starts. If it goes away because you want to pay yourself above the norm, then the business hurts,” said Mahler.mah
You could give yourself a draw or salary from day one, but if you don’t have to shave anything off the business’s profits for yourself in the first six months, you shouldn’t, advises Mahler. He says if you can reinvest everything back into growing the business for the first six months, you should go that route.
Roberto Castellón, a certified SBDC consultant, recommends owners not take any income until the company has been operating for enough time to get a sense of your cash flow.
“Wait until you see how much you sell what your expenses are and how much you have in the bank,” said Castellón.
He says paying yourself a consistent salary becomes easier the more you can plan ahead. If your business operates in cash, paying a consistent salary is easier since you’ll likely have liquid assets in the bank, as opposed to having an inventory and accounts receivables since a late receivable or unsold inventory may throw your accounting off.
If you can get support…
“If your spouse can support the both of you as you launch the small business, I say reinvest it back in to the small business to areas like marketing, branding and the like,” said Mahler.
If you and your spouse agree to that arrangement, you may want to have a written promise between the two of you to pay back the amount at some point. Most importantly, you should set a deadline for when you expect to start bringing home a paycheck.
“I have seen the strongest of marriages fail simply because the spouse got tired of supporting something that was not coming to fruition and the other spouse was not willing to surrender the idea to the failed idea category yet,” said Mahler.
When the deadline comes, if you still aren’t bringing home an income, you may decide to go back to a salaried position and run your business on the side.
If you are seeking funding…
If you are seeking funding, you should pay yourself something because investors expect you to, says Mahler.
“What investors don’t appreciate is overcompensation,” said Mahler. “Anyone who provides you with some startup capital is not interested in seeing their hard-earned money go to a lavish salary for yourself. They want to see the business succeed as much as you do.”
He says he’s seen startup founders take $20,000 monthly salaries from the start. Granted, the business they were operating was a health care startup and involved owning a hospital.
“Again if the business can afford it, then I support it, but at the same time, be reasonable. Could you use that money in other areas of the business to grow it?” Mahler pointed out.
He says he has also seen founders on the other end of the spectrum reinvest everything back into the company and miss credit card payments.
“No one expects you to live on nothing and expect to make a business thrive,” said Mahler. “There is nothing wrong with working a side job to make some cash as you grow this business. Everyone needs the lifeline of a check to survive. They get it.”
The bottom line
While you should make sure you’re earning enough from one resource or another to survive, your pay shouldn’t be your main concern starting out says Stunzi. Instead, you should be focused on growing the business over time.
“If it’s your first startup and you’re worried about your salary, you should maybe reconsider starting the business,” says Stunzi. “You need to be long-term greedy when you start a business, not focused on your paycheck.”
Overall, when it comes to setting your income as an entrepreneur, your goal should be to cover your basic needs and avoid taking too much away from the business’s financial resources, and, as a result, its long-term growth.