People usually don’t talk about their salary in the corporate world.
If you’ve ever been in a corporate career, you know this. Money is a taboo topic, so when you start a small business, it can be hard to know how much to pay yourself as a business owner. In an effort to avoid overpaying themselves, I’ve seen business owners pay themselves the bare minimum.
We don’t want either scenario to happen! You’re running a business to make a profit, so calculating an accurate income for yourself is imperative. Read on for 5 considerations when determining how much to pay yourself.
1. Follow IRS Rules
First of all, you can’t just pay yourself what you WANT to pay yourself. There are some IRS rules* you need to follow and things you need to look at in terms of how your business runs. That will differ for every industry, location and role, and it will even change over time. What you might pay yourself in the beginning of your business will likely be different 2 years in, and very different 5 and 10 years in. It will adapt with your business as well as your role in the business.
But there are some ways you can and cannot pay yourself, depending on how you file your taxes (and be sure to talk to your qualified tax professional about this). This is the first and most important consideration when deciding how much to pay yourself.
For example, if you file your business taxes on a Schedule C on Form 1040 as a sole proprietor, you cannot pay yourself on payroll with withholding taxes. This is a mistake I’ve seen multiple times, even from people who are professional tax preparers. Working with a qualified tax professional can help business owners avoid these types of mistakes.
2. Consider Your Stage of Business
Second, you have to look at what stage your business is in. In the beginning, you aren’t going to pay yourself a consistent paycheck because you have a lot of upfront and unexpected costs, like legal and professional fees. Instead of paying yourself, think of these costs as reinvesting in the business so it can grow.
Once you reach a plateau in your business, that’s when you can establish how much you can pay yourself. When you know the minimum amount of money you’ll be bringing in every month, that’s a good sign to begin paying yourself – even if it’s just a small percentage.
3. Consistency is Key
Once you’ve reached the stage of plateau in your business, remember that consistency in your salary is crucial.
Don’t pay yourself $10,000 one month, $5,000 another month, and $1,000 another month. That doesn’t allow you to know what your business expenses will be each month (because paying yourself is a business expense!), and it doesn’t allow you to know what your personal income will be each month.
Keep it consistent. Start at a reasonable amount that allows you to stay consistent and build from there. You can always give yourself a bonus after a great launch!
4. Know Your Reasonable Compensation
Another huge consideration once you’ve reached a plateau stage is knowing your reasonable owner’s compensation. The IRS has rules about what is considered reasonable compensation. It’s important that you don’t underpay OR overpay yourself, because then you’ll be underpaying or overpaying in payroll taxes and income taxes.
For instance, in a business owner’s first year in business, let’s say they filed as a sole proprietor because they didn’t make enough money to pay themselves on payroll. The following year, due to advice from their accountant, they filed as an S-Corp.
Now, because they’re an S-Corp, they’ll be paying themselves on payroll. They’ll designate a specific salary to themselves as the owner, which has to be a reasonable amount based on their job duties etc. Their accountant will help them do the research on what is a reasonable amount for their business specifically. When they set their salary, they’ll be careful not to set it higher than what they determine to be reasonable compensation, because they’ll end up overpaying payroll taxes. Remember, they’ll pay taxes on their salary as if they’re an employee!
But if you underpay, the IRS will have grounds to say you’ve underpaid on taxes and reclassify distributions as payroll. It’s all about finding the sweet spot of your reasonable compensation.
Be sure to talk to your tax professional to find out where that is.
5. A Note on Profit First
Finally, I want to make a note about a popular book that many business owners use to know how much to pay themselves.
If you’ve been in the business world for any amount of time, you’ve probably heard of Profit First by Mike Michalowicz. The book presents a method that states every time you get a deposit from sales, you should set aside a predetermined percentage of that money as profit. For anyone who’s read the book, here are my thoughts on that.
It’s a great starting point. If you have no other advice or money management systems, it’s a great place to start because it’s better than nothing. BUT the amount of bank accounts as multiple banks can also be very overwhelming.
Typically, once you start moving past the beginning stages of your business, a 1% or 5% figure will no longer work. There will be more calculations to it, and the Profit First ‘basics’ will no longer serve you.
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*Disclaimer: This article is not meant to be tax advice. This is not an all-inclusive list of business advice. Different rules may apply to each individual taxpayer’s specific situation. Please consult with your accountant.