Those who’ve never intimately experienced being a business owner tend to have a rather romanticized vision of what it means to be an entrepreneur. They imagine business tycoons who have it all together, who know exactly what they’re doing, who have a plan for everything. Business owners are automatically experts, right? They’re the boss, so they must be totally qualified for every step of the journey.
If you’ve ever been an entrepreneur, on the other hand… Well, you probably have a much different picture.
Sure, you likely know a great deal about the product or service you’re offering. Maybe you even have a business degree! But even still, most of the time, you find yourself hopelessly Googling everything:
- How to start a business
- How to write a business plan
- How to set up business finances
- How to figure out what I’m doing and stop Googling everything…
And on and on and on.
It’s remarkably common for entrepreneurs to feel in over their heads, or even a bit like a fraud. That first picture—the outside perception—gets stuck in our heads, and it becomes the expectation we hold for ourselves.
So when you don’t yet know exactly what you’re doing, when your business isn’t yet profitable, when you haven’t yet achieved that first image of doing entrepreneurship the “right” way—should you be taking a salary?
In a word: yes!
At least to some extent.
Think about it. You’ve probably worked harder at launching your business than you ever have at any other job in your life. It’s a 24 hours a day, 7 days a week job that never ends. You’ve poured blood, sweat, tears, and sleepless nights into making this dream a reality. It might not be perfect yet, and you might not have it all together—but you need to at least plan to receive some compensation for it!
In this guide, we’ll review the different types of entrepreneur salary options for business owners; discuss the pros, cons, and legal implications of how and when to take a paycheck; and help you decide exactly how much you should be paying yourself.
There’s no precise equation for determining how entrepreneurs should pay themselves, as the right choice varies dramatically by your business type, age, financial health, and more. That said, we hope this guide will help to steer you in the right direction.
Business and Personal Finances
In those fuzzy early days when managing your business happens in the twilight hours when your day job is done, too many entrepreneurs blur the lines between business and personal finances. Before you even start to discuss how to pay yourself, it’s essential that you first make a plan to track expenses and income for your business separately, starting with distinct banking accounts for your business.
Mixing business and personal finances not only causes accounting headaches—it can ruin your chances at securing a small business loan and get you into hot water with the IRS. If you’re still using the same bank account to manage your business and personal finances, fix this today.
If you haven’t already, call your current bank to set up a business account, or research banks in your area that are small business friendly. Get checks for your business checking account and apply for a business credit card that you pay regularly from your business bank account.
Pick the Right Kind of Entrepreneur Salary
Once your business and personal finances are separated and organized, you’ll need to start considering how to pay yourself.
But before you weigh the pros and cons of different compensation amounts and timing, your decision about how and when to take a paycheck will depend on the structure of your business.
The IRS’s requirements for owner compensation are different for corporations, sole proprietorships, partnerships, and LLCs, so you’ll need to first determine what your legal rights and obligations are.
Not sure what type of business you have? Take a look at the SBA’s definitions of business entity types.
For the most part, there are two main ways to pay yourself an entrepreneur salary: with a regular salary or through owner’s draws.
1. Salary Method
The salary method is essentially just like getting paid in the workforce at large. You’re paid on a regular schedule, either based on hours worked or at a flat rate.
In fact, if you’re an officer of a corporation or the owner of an S Corporation, you’re legally required to receive a regular salary with withholdings for Social Security, Medicare, and federal and state income taxes.
2. Owner’s Draw Method
An owner’s draw is a withdrawal from your company’s profits—profits, not revenues—payable to you, the owner. Make sure that you’re accounting for all expenses (rent, utilities, employee salaries and benefits, supplies, equipment needs, and all the rest) when you calculate how much you can safely afford to take out of your business for your own pocket, and when.
This means you need to know your company’s profit and loss statements inside and out before making this decision.
Draws are not subject to withholding for Medicare, Social Security, or income tax at the time they’re paid out—but remember that you’ll still have to report that income and pay equivalent taxes on it at the end of the year. If you do take draws, keep pristine records and consistently set aside money for taxes so you’re not taken unawares come Tax Day. Your accounting program can also automate this process for you.
Sole proprietors, partners, and owners of LLCs aren’t subject to the same rules as corporations. What’s left over after deducting expenses on Form 1040 Schedule C (for sole proprietorships) or Form 1065 (for partnerships) is profit and viewed by the IRS as the owner’s personal income.
Essentially, these business owners are self-employed: as such, they can pay themselves however they want, draw or salary. S Corporation owners can also take a draw on top of their salary.
The Benefits of Paying Yourself an Entrepreneur Salary (Even if You Don’t Have to)
Although sole proprietors or partners aren’t required to receive a salary (with the associated withholdings), it’s a good idea to do so anyway.
For one thing, paying yourself a salary indicates commitment in the eyes of your employees and investors.
It proves that your own financial well-being depends on the financial success of your business’s success. Likewise, a salary shows the IRS that your business is a legitimate business, not just a hobby that happens to bring in some cash.
Building in a salary (even just a small one) for yourself from the very beginning will not only make your personal finances more manageable, it will also help you to keep accurate financial records and see the big picture of your company’s well-being by establishing a clearer picture from the start of what the company costs to run.
When receiving a salary, all employers must receive “reasonable compensation” according to the IRS—which is, essentially, a figure comparable to the salary of an employee in your role at another business.
But what the heck does “reasonable compensation” for your work as a business owner look like?
One way to calculate this number, especially early in your business’s growth, is by looking at what you need to cover your basic living expenses.
If you’re concerned about covering fluctuating costs, consider setting your salary as a percentage of profits rather than a fixed yearly amount. This is best for businesses who have been running for a few years and are currently turning a fairly steady profit. Then, if your business does better than expected in a given year, you can give yourself a bonus!
Pay Day! Setting a Payment Schedule
Just as with the amount of your salary, the scheduling of your paychecks as an owner should be comparable to that of an employee in a similar role at a similar business.
Common salary schedules in the U.S. are once a week or twice a month: these schedules provide good frameworks for your own salary as well.
If you’re paying yourself through the draw system, keep to a consistent schedule as much as possible. Inconsistent draws might look fishy to the IRS—and can even trigger a tax audit of your company. Sticking to a schedule will prevent big fluctuations in your company’s cash flow (as well as in your personal finances) and will assure the IRS that everything’s on the books.
Calculating Your Compensation
Ultimately, there’s no magic formula to calculate how much to pay yourself, starting when, or through which method. It’s an incredibly business-specific question that depends on a wide number of practical and personal factors.
That said, we’ve created a checklist of questions to think about:
1. Comparable Salary
If you were hired by someone else to do the job you’re doing now, what would your salary be?
That said, figuring out your market value can be tricky if—like many small business owners—you wear about a million different hats in a single day!
So if finding a matching job description isn’t working, take the opposite approach. List out the most common responsibilities you take on, then determine what it would cost you to outsource those tasks to someone else.
That combined number is sometimes called your “true wage.”
2. The Tax Factor
Depending on your business’s entity type and whether you’re taking a salary or draws, there are tax pros and cons to taking a payout versus reinvesting in your company. Make sure you’ve educated yourself on these pros and cons and plan ahead.
Consult with a capable accountant—ideally your business’s own, but a public accountant if you don’t have one is fine—to find out specifically which tax regulations affect your company and how.
An accountant can also help you find ways to make the most of deductions, shareholder distributions, and other tax breaks that will help you find the cash to pay yourself.
That said, investing some funds back into the company (rather than taking them as compensation) is another way to help minimize tax burdens.
3. Your Employees’ Compensation
Solopreneurs can ignore this section—but if you have one or a few employees, this factor is important to consider.
Of course you’re working on and thinking about your business morning, noon, and night—but probably, so are a few other people. If you’ve attracted top talent on the cheap with promises of equity or bonuses down the line, paying yourself a fat salary in the meantime is a lethal morale move.
At the same time, not paying yourself at all isn’t necessarily the right move here, either. In fact, experts have shown that paying yourself a salary is actually an indicator of your commitment in the eyes of your employees because it proves that you’re invested. That is, your own financial well-being depends on the financial success of the business.
4. Cash Flow
Issues with cash flow are the first and most immediate factor that can kill the success of an otherwise thriving business—so this factor will have a big impact on the salary you take as a business owner. You don’t need to be hugely profitable from the start necessarily, but if your business can’t pay basic expenses like rent on an office/retail space, employee payroll, and inventory costs, you won’t be in business for long.
Before you decide on what to pay yourself as a business owner, it’s time to get extremely familiar with your company’s financial reports. Talk to your accountant to gain more insight into your company’s cash flow to determine what you can afford.
If your company isn’t yet turning enough of a profit to pay you, it might be time to consider raising prices to make that happen. You can also take an I.O.U. from your business—but keep in mind that if your business is only making ends meet in the long-term because you’re not taking a salary, your company could be in trouble.
5. Growth Rate
If your company is growing quickly, you might need all the working capital you can get in order to afford new costs.
Typically every opportunity that arises comes with its own associated cost, so not having that access to working capital can dramatically hinder your ability to continue growing. If you’re taking out more salary than you need, you may force yourself to take on added investments or expensive loans in order to afford that growth trajectory.
Of course you need to be able to cover your basic expenses. That said, keep in mind planning for growth in order to avoid debts that may cost you more in the long-run.
6. What You Can Afford
While we’ve listed this factor last, it is in some ways the most important consideration as you determine how and when to pay yourself. That is, how much or little can you or your family reasonably afford to live on?
Some entrepreneurs find themselves in a fortunate position in which taking no or little salary for a while isn’t really a big deal. Perhaps your spouse brings home a solid salary for your family, you benefit from an inheritance or family trust, or you’re living off earnings from a business you’ve launched and sold in the past.
If that’s the case and you’d rather double down on growing your business by not taking out extra working capital—by all means! You can absolutely take out the minimum amount required by law, depending on your business’s legal structure.
On the other hand, if you do need to rely on income from your business in the short term, it’s important that you make a plan immediately to do so, at least to a modest degree. After all, even if your primary motivation isn’t financial, running your business won’t be sustainable if you’re worried about covering your family’s basic living expenses.
And if you don’t have what you need to sustain the basics of your personal finances, why exactly are you doing this?
Making the Move to Pay Yourself
Deciding exactly how much to pay yourself when you start a business is both an emotional and practical decision.
It’s easy to dream about those business tycoons who seem have it all and either sell yourself short (“Seriously, I have to Google everything!”) or, maybe just as bad, give yourself an unnecessary ego boost (“I’m kind of a big deal.”). One can be unfair to your personal expenses and needs, and the other can be deadly for growth and cash flow.
While there’s no exact equation for determining when or how much, the best way to avoid any emotional hemming and hawing is to think of your compensation strictly in terms of business. What’s in the long-term best interest of your company? With this mind, you’ll ultimately take home what’s fair for your business—and yourself.
The post The Entrepreneur Salary: How to Decide How Much (And When) to Pay Yourself appeared first on Fundera Ledger.
from Fundera Ledger https://www.fundera.com/blog/2016/05/18/entrepreneur-salary/