As a business owner, it may be second nature to remember to pay your employees or adequately invest in your business. However, it’s just as important to compensate yourself for your contributions to the business.
“It’s essential to strike a balance between paying yourself fairly and ensuring that your business has enough capital to cover operational costs, growth initiatives, and unforeseen expenses,” said Paul Miller, CPA and Managing Partner at Miller & Company LLP.
Here’s how to determine when and how to pay yourself.
Ways to pay yourself as a business owner
There are two common ways small business owners can pay themselves in their business:
Salary
With the salary option, you can pay yourself just as you would your employees — including withholding taxes. The salary method is more stable, as you can set up weekly, biweekly, or monthly payments through payroll. However, there isn’t much flexibility if you need to cut your pay when the business isn’t as profitable.
Bonuses can be a great way to supplement a business owner’s salary when the business is performing well. You can give yourself bonuses at the end of every quarter or wait until the end of the year.
Owner draw
Through an owner’s draw, you can withdraw money from the company’s checking account as needed without withholding employment taxes. Although you won’t need to pay taxes for each draw up front, you will have to pay self-employment taxes either quarterly or annually when you file your tax return.
This is the most flexible option, as it allows you to withdraw varying amounts of cash as needed. It is also the most unpredictable option. You cannot count on a regular paycheck, and you won’t even know how much money you’ll be able to withdraw until profits are fully reported for the month.
[Read more: What Is Variable Pay and How Can It Help Small Businesses?]
How does business structure influence owner pay?
Depending on your business structure, certain payment options may make more sense than others:
- Corporations: Owners of C corporations are considered employees of their own business and can pay themselves a regular salary, which is taxed separately from their business profits. They might also receive shareholder dividends. With an S corporation, you can receive a salary as well as take out distributions, but the salary must be “reasonable” according to IRS guidelines and in comparison to similar positions in your industry.
- Pass-through entities: Owners of pass-through entities like sole proprietorships, partnerships, and LLCs (if taxed as a sole proprietorship or partnership) typically pay themselves through owner draws. Owners can make regular withdrawals from the business's profits, but they are not considered employees. In partnerships, these withdrawals might include guaranteed payments, which are akin to a salary but are not subject to payroll taxes.
“Consider the tax implications of different pay structures, such as whether you take a salary, dividends, or a combination of both,” Miller told CO—. “This decision can significantly impact your personal tax liabilities and the business’s tax obligations.”
Planning (and saving) throughout the year is necessary to keep tax payments from adding up.
How much should you pay yourself?
Small business owners in the United States make between $83,000 to $126,000 on average, depending on their industry and location. Keep in mind that many business owners do not take a salary in the first couple of years. Others may pay themselves too much and limit the growth of their business.
To ensure the financial health of both you and your business at any stage of growth, Brittney Suttle, CPA and Owner of Knies & Co. Accounting, recommended the “Modified Profit First Method.” In this method, you’ll allocate a certain percentage of revenue toward tax savings and your take-home pay.
“The percentage you allocate can greatly fluctuate business-to-business based on expenses … but it's a great method that can grow with you as your business grows,” she said.
For cyclical or seasonal businesses, Suttle advised allocating your pay percentage to a separate Owner’s Pay Savings account, then taking a consistent paycheck from that account throughout the year.
“The amount in those high-dollar months should cover those low-dollar months while allowing you to consistently get paid on a personal level,” she added.
[Read more: How to Do A Competitive Salary Analysis]
Tips for setting your compensation
As a business owner, you should pay yourself enough to live on, but be realistic about what you need. Follow these tips to compensate yourself fairly without putting your business in financial jeopardy.
Calculate your net income
Calculating your net income ensures your business can cover expenses before calculating your own pay. This step is crucial to avoid debt or even bankruptcy. First, subtract the cost of your business’s expenses (such as employees’ salaries, rent for your office space, etc.) from your gross revenue to find your net income. Once you subtract the amount of taxes to set aside, you will pull your pay from this figure.
Consider tax savings
Planning (and saving) throughout the year is necessary to keep tax payments from adding up. According to the IRS, most corporations and self-employed business owners that will incur over $1,000 in tax payments per year are required to submit and pay estimated quarterly taxes. Whether you are a new or existing business owner, confer with an accountant to find the tax specifications required for your business and to avoid incurring penalties.
Tax calculations should always occur before taking expenses out. A good rule of thumb is to save 30% of your income for taxes. This percentage may be higher if you or your joint filing partner are in a higher tax bracket.
[Read more: The Most Common Business Entities for Startups]
Factor in your business debt
After accounting for tax payments, you can use these funds to pay off your business’s debt. If you’ve taken out any loans or used a credit card, your lender most likely requires a minimum payment each month. Subtract that total minimum debt payment from your net monthly income. If you have extra funding left over after paying yourself, you can increase your monthly payments and clear your debt more quickly.
Create a business savings plan
Build up a savings buffer while you have the money for any new hires, training programs, or emergency funds. Figure out which goals are most important to you and which you can put on hold. Your future self will appreciate the effort you take to set aside funds for your business goals and divide them into monthly savings.
Prepare to adjust your pay over time
As your business evolves, the best method and amount to pay yourself may change, too.
“Once you see excess cash building up in your business bank account or your revenue and/or net profit margin percentage improving, you typically can give yourself a pay raise,” said Suttle.
Miller noted that changes in tax laws or your personal financial needs might also prompt you to revisit how you’re paying yourself — for example, shifting from a salary to a dividend or vice versa.
“Regularly review your compensation strategy with a financial advisor or CPA to ensure it remains aligned with both your business and personal financial goals,” Miller advised.
CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.
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