You may have any number of reasons for starting your own business – doing something you love, being your own boss, creating a venture you can pass onto your children, or something else entirely. But at the end of the day, it’s a business and you’re trying to make a living. That means you have to get money out of your business somehow. Many small business owners have a hard time deciding just how to do that and how much to pay themselves. It can be a tough number to pin down – too much and you may jeopardize the financial health of your company, too little and you jeopardize your own finances.
In addition to how much you pay yourself, you’ll have to decide on a way to pay yourself. That element will depend largely on how you choose to organize your business.
Your Business Structure and Your Pay
Before we talk about how to decide on how much to pay yourself, you need to understand the different ways you can pay yourself. It’s not as simple as grabbing the cash left in the register at the end of the day. As we just mentioned, your options depend on your business structure.
A sole proprietorship is the simplest of business entities. As a sole proprietor, all business income is considered your income. When you’re heading up a sole proprietorship, you report taxes using a Schedule C and a Standard Form 1040. Essentially, you and the business are considered the same entity and any profits the business makes are automatically considered to be your income.
You can pull money from your sole proprietorship at any time, but remember to keep careful records of what you’re pulling out so that your accountant can handle it properly on your annual tax return. Certain withdrawals may be treated differently.
If you’re working as a sole proprietor, you’ll probably need to pay quarterly withholding taxes to the IRS, which also means filing a quarterly return. Talk to your accountant to determine what you need to do.
Partnerships are like sole proprietorships, but with multiple owners. Partnerships profits pass through to the partners as income, just like a sole proprietorship. For tax purposes, a partnership will file a Schedule K-1 and Form 1065 with the IRS. As with sole proprietorships, partners may also pay themselves out of the profits of their businesses at any time.
Again, you may be required to file quarterly returns and pay quarterly withholding taxes, so talk to your accountant.
Limited Liability Corporations (“LLC”)
An LLC melds the tax pass-through of partnerships with certain protections of a corporation, such as limiting personal liability for debts and legal issues. As far as paying yourself goes, the profits are considered to be part of your income, much like a sole proprietorship or partnership.
LLCs and Corporations both require formal legal registration. When starting up your LLC or Corporation, you should take the proper steps to ensure that you’re in compliance with all state and federal registration laws. Proper registration of these business entities entitles you to certain legal protections.
Talk to your accountant about whether you need to file quarterly returns and pay quarterly withholding taxes.
S Corporations (S Corp)
When you incorporate your business, you can choose between becoming an S corp or a C corp. An S Corp structure is a popular choice among small business owners; it offers many of the legal protections of a regular C corp but has a different tax structure. S corps are taxed like partnerships, with all profits and losses passing directly through to the owners. The corporation is not taxed as its own entity.
The law requires officers in both S and C corporations to be part of the documented payroll. In other words, you’ll have to pay yourself if you’re working as an officer. As with any paycheck, that comes with withholding for taxes, Social Security, and Medicare. Whatever income you earn as an owner is still taxed at your personal rate but is not subject to the standard payroll taxes.
You may need to file quarterly returns and pay quarterly withholding taxes on the income that gets passed through to you, so you’ll need to work with your accountant.
C Corporations (C Corp)
C corps are somewhat less popular among small business owners, since the requirements and rules are more complex than other forms. C corps offer the most legal protection and the most flexibility as far as dealing with investors and expanding (or contracting) ownership, but you’ll need to follow all the technical legal procedures in order to get those benefits. C corps also offer different options as far as paying yourself.
If you’re working for the C corp, you can pay yourself a salary with all the standard payroll taxes. You can also pay yourself in the form of a “dividend.” A dividend is a payment made to stockholders. Dividends are described in terms of a dollar amount per share – like $2 per share, so you’d get $500 if you own 250 shares. You generally have to pay a 15% tax on dividends rather than the rate of your personal bracket. Depending on your bracket, dividends may be cheaper than a salary.
However, dividends involve other complications. First, the accounting can be tricky and probably requires the help of a professional. Second, dividends are double taxed – the corporation can’t deduct them, so the business pays the full tax on that amount and you pay an additional 15% on what you get. And if there are multiple owners, you’ll have to get everyone to agree on a dividend payment and rate and everyone will have to get the same rate.
Note that you can set up a C corp with just one owner; you don’t have to have a large group of shareholders. Then you can set salaries and dividends however you like. Just remember to carefully follow the rules (talk to your attorney to make sure you’re doing it right) or the IRS may decide to treat you as a sole proprietorship.
If you’re the owner of a pass-through entity (a sole proprietorship, partnership, LLC, or S Corp), you’re generally just going to take the profits of the company when you want to and that’s your income. Whether you actually pull that money out of the company or not, you’ll be taxed on it in the year that the company earned that money. If your company is registered as a separate entity (anything but a sole proprietorship), you may choose to pay yourself a salary. If your personal tax rate is lower than the company’s, it makes sense to pay the company’s full profit to yourself as a salary. If not, then you’ll want to take out a reasonable amount and leave the rest in the company.
Note that for companies with multiple owners, you’ll have to get everyone on board with the pay arrangements. Some groups may prefer to set salaries for any owners working within the company, to ensure that those people are paid for their work and don’t just get the benefits of their proportion of the profits. Some groups may also want to limit the ability of individuals to draw out profits at any time or take out loans. And if you’re in a C corp, you’ll need the shareholders to agree on a salary, dividend, and loan policy.
How Much Salary Should You Pay Yourself?
Now that you know the options for paying yourself, you face the big question: how much? Of course, the answer depends on a number of factors.
According to the IRS, “reasonable compensation” is what you should pay yourself. Obviously, that is a nebulous, imprecise term. How do you determine what that means? The IRS states that “Wages paid to you as an officer of a corporation should generally be commensurate with your duties. Refer to “Employee’s Pay, Tests for Deducting Pay” in Publication 535, Business Expenses” for more information. In other words, you’ll need to give yourself a market wage.
In general, a market wage is a good idea. That means you know how much pay to expect and that your company is running in a comparable fashion to others. If you can’t cover a market wage, your company may not be running efficiently. If you have way more cash than you need, you may be missing opportunities for growth.
Look at other people doing similar work in your area are doing and pay yourself similarly. That’s it – there’s no hard math, just a general number range for the same kind of work.
Even if you aren’t required by law to pay yourself a salary (market or otherwise), it’s a good idea. In the words of Alice Bredin, a B2B marketing entrepreneur and small business adviser for OPEN, “Compensating yourself is important for you and your company,” Bredin told Business News Daily. “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.”
Your pay is just one of a million things you’ll have to consider as you start and run your own business. The amount is something that you can change over time, but you’ll need to think about your payment options up front as you decide on a corporate structure. Do you want to be able to pay dividends? C corp or nothing. Is a pass-through entity better for tax reasons? C corp isn’t the move. Talk to your accountant and attorney to get a sense of what might be best for you.
And as for the amount, treat yourself like you would any other employee. If you were to hire someone to do your job, what would you pay them? That’s the amount you should pay yourself.