As a business owner, when you’re thinking about your business expenses, your own salary is one of the easiest items to overlook.
According to the 2016 American Express OPEN Small Business Monitor, just over half (51 percent) of business owners pay themselves a salary. But Alice Bredin, a B2B marketing entrepreneur and small business advisor for OPEN, emphasized the importance of including your own pay in the budget as soon as you can afford to do so.
“Compensating yourself is important for you and your company,” Bredin said. “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.”
You may be tempted to work for free, but you should recognize that your time has value. “Some entrepreneurs work for free for much too long,” said Evan Singer, CEO of SmartBiz Loans, a provider of Small Business Administration (SBA) loans. “It’s no surprise that anxiety and worry about personal finances are not conducive to building and running an enterprise. If you’ve established a small business, it’s important to realize that your time is valuable.”
There’s also a practical reason to pay yourself as a small business owner: Depending on your company’s organizational structure, you may be able to give yourself a tax break if you designate a personal salary out of your total business income.
“Let’s say you’re making a net income of $100,000 a year in your business, and you file as a sole proprietor: Self-employment tax – which consists of Social Security and Medicare – will be calculated from the full $100,000,” explained Whitney Delaney, founder of Delaney Tax & Wealth Management. “On the other hand, if you’re an S corporation and you pay yourself a salary, your [deductions] will be based [only] on your salary rather than your total net revenue.” [Learn the difference between net income and gross income.]
When money is tight, an owner’s salary is often the last priority on the small business budget. But as your business income becomes more stable, paying yourself becomes feasible.
Delaney advised asking yourself three questions to determine if you’re ready to start paying yourself a salary:
Delaney said if you can answer “yes” to all three, you can afford to pay yourself. Singer agreed, noting that businesses that are past startup mode and are more firmly established can consider budgeting for owners’ salaries.
According to the IRS, business owners should pay themselves a “reasonable salary.” But how do you determine what’s reasonable?
“I advise paying yourself a modest salary, as modest as you can afford,” Delaney said. “Taking the fiscally conservative road [means] you’ll incur fewer taxes, which leaves more money for you to invest into your business.”
Here are two standard ways to determine your salary:
To get a specific number for your salary, Bredin recommends calculating your basic personal expenses first. Then, based on that figure, look through your business numbers and determine what you can afford to take.
“It can be daunting to calculate what that salary number should be, and because it’s so tricky, I recommend calling the accountant who prepares your taxes to get advice on how much to pay yourself,” Delaney added.
An alternative method is to pay yourself based on your profits. The SBA reports that most small business owners limit their salaries to 50% of profits, Singer said. However, he noted that even the SBA doesn’t have a definitive answer on compensation for small business owners because this amount is highly dependent on a business’s development stage.
“To give you guidance, the SBA maintains a database of income statistics,” Singer said. “Information [in the database] 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 also] you’ll learn if the salaries you are paying your employees are fair.”
Singer reminds business owners that no matter which formula they use to determine compensation, they should ensure their salaries don’t hurt day-to-day operations. “Cash flow can make or break a small business.” [Follow these cash flow strategies for survival.]
Based on guidance from Bredin, Delaney, Singer, and other experts, here are a few rules of thumb for structuring owner compensation for a small business or solo operation:
Of course, setting up your salary as the owner of a business can also entail some crucial decisions about your personal and business taxes. For these considerations, enlist the help of a professional. If you have a CPA, consult with them before making any decisions. If you don’t, find one who can help you.
Dock Treece contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.