Compensation is top of mind for entrepreneurs, especially as the 2020/2021 COVID-19 pandemic continues to impact the economy. BizBuySell® recently surveyed entrepreneurs asking why they want to start a small business. Fifty-two percent reported that they were seeking better income opportunities.
A question we come across frequently on blogs and social media is “How much should I pay myself when running my small business?” Even the Small Business Administration (SBA) doesn’t have a definitive answer, as they state, “ There is no magic formula for setting your salary because so much depends on the development stage of your business and how it’s doing .” Although that answer is vague, there are several ways you can approach salary that will help you feel comfortable about your paycheck.
Two ways to pay yourself
There are two main ways business owners can pay themselves:
Salary: You pay yourself a fixed, regular salary. With this type of compensation, you’re paid as if you are an employee of the company and taxes are taken from your paycheck. This is legally required for businesses that are structured as S-corporations or C-corporations or a limited liability company taxed as a corporation. The IRS has a “ reasonable” compensation requirement,” which means your salary should be comparable with what someone else doing the same job in your industry would be paid.
Owner’s draw: The business owner draws money (in cash or in kind) from the business profits on an as-needed basis. You can draw up to the amount you put into the business, which is known as owner’s equity. You don’t have to pay taxes upfront every time you take a draw, but it’s wise to set aside money regularly to budget for your tax bill.
Here’s the good and the bad about these two methods:
Pros of taking a salary
- Flexibility. Your draw can depend on business performance.
- Stable, recurring expense to budget into your business costs.
- Taxes are deducted upfront.
Cons of taking a salary
- Your salary must follow the reasonable compensation rule even when business is bad.
- Not flexible.
Pros of taking a draw
- Your draw can depend on business performance.
Cons of taking a draw
- You need to budget for a tax bill at the end of the year.
How much should you take in compensation?
Set a salary as a percentage of profits
Assess your small business’ past performance to find a profit number to set as a benchmark. After you have that number, factor in business costs, taxes, and future growth plans. Then, from there, determine what an appropriate percentage of that figure would be as your tentative salary. The SBA reports that most small businesses limit their salary percentage to 50 percent of profits.
Determine your salary based on expenses
If you use this method, your salary depends on your personal living expenses. First, calculate all your expenses -- from rent to groceries to transportation. Include everything like payments on credit cards, personal taxes, and entertainment costs. After you’ve come up with a comprehensive list of your expenses, divide the total number by 12 to determine the monthly salary you need to receive to keep you from dipping into your personal savings or relying on credit cards. This will show the minimum monthly salary you’ll need to stay afloat while growing your small business.
Startup salary calculation
If you are still in startup mode and have no profit history, review your own personal costs. What do you need to support a frugal, startup lifestyle? Look at housing, transportation, food, entertainment, etc. Consider postponing expenses for anything above your living costs until you start turning a profit.
Check out the data
The SBA maintains a database of income statistics. Information 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 you’ll also discover if the salaries you are paying your employees in your industry are fair.
Seek expert advice
It’s a best practice to work with your accountant or a bookkeeper to determine the best method to pay yourself a reasonable salary. Here’s an article to help you find a financial professional, if needed: How to Find a Small Business Accountant.
The number one reason most people want to become their own boss is the freedom, satisfaction, and flexibility it offers them. However, if you’re not getting the compensation you need – and deserve – you might find yourself unhappy. This can result in a poor work environment and jeopardize future business growth. So, take your well-deserved compensation so you can successfully move forward and feel good about your entrepreneurial journey.
WHAT YOU NEED TO KNOW: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult legal and financial processionals for further information.