As a business owner with a thousand responsibilities and your own company expenses to think about, factoring in how to pay your own salary can easily fall to the back burner. But when it comes to optimizing your business’s financial performance, retaining top employees and building a long-lasting, successful company, how you choose to pay your own salary matters.
Your business’s structure will be a major factor, and experts like Alice Brendin, a B2B marketing entrepreneur and small business advisor, said it’s important to include your own pay in the budget as soon as you can afford to do so. By prioritizing your own salary structure, you can set your company up for long term success.
How to pay yourself as a business owner
According to the IRS, business owners should pay themselves a “reasonable salary.” But how do you determine what’s reasonable?
“I advise paying yourself a modest salary, as modest as you can afford,” said Whitney Delaney, founder of Delaney Tax & Wealth Management. “Taking the fiscally conservative road [means] you’ll incur fewer taxes, which leaves more money for you to invest into your business.”
Here are two standard ways to determine your salary:
- Base your salary on personal expenses.
- Use profit distributions as salary.
Base your salary on personal expenses
To get a specific number for your salary, Bredin recommends calculating your basic personal expenses first. Then, based on that figure, look through your business numbers and determine what you can afford to take.
“It can be daunting to calculate what that salary number should be, and because it’s so tricky, I recommend calling the accountant who prepares your taxes to get advice on how much to pay yourself,” Delaney added.
To find the right accountant for your small business, consult the American Institute of Certified Public Accountants (AICPA), which has a license verification directory of CPAs.
Profit distributions as a salary
An alternative method is to pay yourself based on your profits. According to Evan Singer, CEO of SmartBiz Loans, a provider of Small Business Administration (SBA) loans, the SBA reports that most small business owners limit their salaries to 50% of profits. However, he noted that even the SBA doesn’t have a definitive answer on compensation for small business owners because this amount is highly dependent on a business’s development stage.
“To give you guidance, the SBA maintains a database of income statistics,” Singer said. “Information [in the database] includes earnings by occupation and education, income statistics, and results from a national compensation survey. Not only will this data help determine your own salary, [but also] you’ll learn if the salaries you are paying your employees are fair.”
Singer reminds business owners that no matter which formula they use to determine compensation, they should ensure their salaries don’t hurt day-to-day operations. “Cash flow can make or break a small business.” [Follow these cash flow strategies for survival.]
Did You Know?
While distributing profits has its upsides, you may be liable for excessive self-employment taxes if that is your primary form of payment.
When can you start paying yourself?
When money is tight, an owner’s salary is often the last priority on the small business budget. But as your business income becomes more stable, paying yourself becomes feasible.
Delaney advised asking yourself three questions to determine if you’re ready to start paying yourself a salary:
- Do I have sustained revenue?
- Do I have steady projected revenue?
- Is my business in the black?
Delaney said if you can answer “yes” to all three, you can afford to pay yourself. Singer agreed, noting that businesses that are past startup mode and are more firmly established can consider budgeting for owners’ salaries.
5 tips for setting your compensation
Based on guidance from Bredin, Delaney, Singer, and other experts, here are a few rules of thumb for structuring owner compensation for a small business or solo operation:
- If your business is established and profitable, pay yourself a regular salary equal to a percentage of your average monthly profit.
- Don’t set your monthly salary to an amount that may stress your company’s finances at any point.
- Consider changing your tax treatment or organization type to an S corporation to reduce your self-employment tax liability.
- Take other profit distributions regularly, but only when those distributions won’t be a burden for the business.
- Periodically review your salary as part of your overall compensation and adjust it up or down based on the business’s revenue and cash needs.
Of course, setting up your salary as the owner of a business can also entail some crucial decisions about your personal and business taxes. For these considerations, enlist the help of a professional. If you have a CPA, consult with them before making any decisions. If you don’t, find one who can help you.
Why does owner compensation matter?
“Compensating yourself is important for you and your company,” Bredin said. “If you are not allocating funds for your own salary, your books do not accurately reflect the health of your company, since your expenses are missing a large cost, namely you. Without factoring in all expenses, you won’t know if you need to raise prices, market more, cut costs, or make other adjustments that will help your company succeed.”
You may be tempted to work for free, but you should recognize that your time has value. “Some entrepreneurs work for free for much too long,” said Singer.. “It’s no surprise that anxiety and worry about personal finances are not conducive to building and running an enterprise. If you’ve established a small business, it’s important to realize that your time is valuable.”
Owner salaries and tax considerations
There’s also a practical reason to pay yourself as a small business owner: Depending on your company’s organizational structure, you may be able to give yourself a tax break if you designate a personal salary out of your total business income. If you’re running a very small business, visit our Best Payroll Services for One Employee page to understand what services are best for your type of company.
“Let’s say you’re making a net income of $100,000 a year in your business, and you file as a sole proprietor: Self-employment tax – which consists of Social Security and Medicare – will be calculated from the full $100,000,” Delaney said. “On the other hand, if you’re an S corporation and you pay yourself a salary, your [deductions] will be based [only] on your salary rather than your total net revenue.” [Learn the difference between net income and gross income.]
Key Takeaway
How you structure your company can significantly impact how your compensation as an owner is taxed.
Structuring your salary is part of building your company
By making hard decisions about how to build your business, you can set your business up to be successful. One of these difficult decisions is your salary structure. By researching and understanding how this financial factor plays into the overall health of your company, you can make the right choice for your business and for yourself.
Dock Treece contributed to this article. Source interviews were conducted for a previous version of this article.
