When you're thinking about your business expenses, one of the easiest items to overlook is your own salary.
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 adviser 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 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."
"Some entrepreneurs work for free for much too long," added Evan Singer, president of SmartBiz, 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 the structure of your company, you may be able to give yourself a tax break if you designate a personal salary out of your total business income. [See Related Story: Quitting Your Day Job? The Basics on Benefits Coverage for Entrepreneurs]
"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," said Whitney Delaney, founder of Delaney Tax and 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."
When can you start paying yourself?
When money is tight, a small business owner's salary is often the last priority on the budget. But as your business income becomes more stable, paying yourself becomes much more feasible.
"After a long, challenging economic period, some business owners are enjoying an uptick in revenue," said Bredin, citing trends identified by American Express OPEN. "Business owners often cut [their own salary] first, even before cutting other expenses and letting employees go. When revenues begin flowing again, and business owners feel more optimistic, they reinstate their pay."
Delaney advised asking yourself three questions to determine if you're ready to start paying yourself a salary:
- Do I have sustained revenue?
- Do I have steady projected revenue?
- Is my business in the black?
If you can answer "yes" to all three, you can afford to pay yourself, Delaney said.
Singer agreed, noting that businesses that are past "startup mode" and are more firmly established can consider budgeting for owners' salaries.
Determining your salary
According to the IRS, business owners should pay themselves a "reasonable salary," said Delaney. 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."
To get a specific number, Bredin advised first calculating your basic personal expenses; then, based on that figure, you can look through your business numbers and determine what you can afford to take for your salary.
"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 percent 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 the development stage your business is in.
"To give you guidance, the SBA maintains a database of income statistics," Singer told Business News Daily. "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 reminded business owners that no matter what formula they use to determine compensation, they should make sure their salaries don't hurt day-to-day operations.
"Cash flow can make or break a small business," he said.