As your business grows, you’re eventually going to be faced with a hard decision.
And that decision is around pay.
No, I’m not talking about paying your employees. So take a breather. This time it is about you.
You need to decide how you’re going to get paid, how, and when. But you’re probably wondering, what is the best salary for small business owners?
How do you decide how much to pay yourself? And what is the best method to pay yourself? For example, there’s owner draws, dividends, distributions, w-2 wages, and so on.
This stuff is really confusing, right?
I certainly understand, as I’ve had to make these decisions myself in my own company, which went on to become an Inc. 5000 fastest-growing company. And I also had the luxury of studying this as a licensed CPA. And I also had the luxury of studying this as a licensed CPA.
So in this post, I’m happy to give you both sides of the stick. I will tell you the business reasons in determining how to pay yourself. I will also tell you some of the tax implications you need to consider so you can avoid those painful IRS audits.
I’m going to show you how I pay myself in my own business, and what you need to consider.
Let’s begin with the common mistakes I see people make when it comes to computing salary for small business owners.
The Risks of Overpaying Yourself
A lot of business owners make a huge mistake by paying themselves too early. And as a result, they suffer severe consequences.
First and foremost, cash is the lifeline of your business. It’s the blood and heartbeat of your business. And if you starve your business of it, you will die.
I really wish I was being dramatic right now, but I’m not. 90% of businesses fail because they run out of cash. Period.
Too many times, business owners take too much cash out of their business. So much so that they don’t even leave enough to pay their expenses. Like seriously, I’ve seen businesses pay themselves a ton of money and not have enough money to even pay their employees.
That aside, when you pay yourself too much, you’re also draining your business potential. For example, Amazon, which is now one of the biggest businesses in the world, was technically “unprofitable” for the first 14-years of their business.
And it wasn’t due to poor budgeting or expense management. They were consciously re-investing into their business. As a result, they grew exponentially faster than anyone could have imagined, have revolutionized their industry, and are one of the largest companies in the world.
Jeff Bezos could have easily been greedy in his early-years, but he wasn’t. And now, greedy people envy his success. Isn’t that crazy?
Anyway, my point here is that before you consider taking a dime out of your business, you need to make sure that your expenses will be covered, and that you’re not starving your strategic goals, that require money, to grow your business.
Now that that’s out of the way, this is how my partners and I pay myself in our business, and what we recommend for any other business.
How Much to Pay Yourself in your Small Business
First, you should have at least 3 months of operating expenses in cash. This will provide you security and peace of mind that your business can stomach any unexpected losses and stay afloat. So if you lose your biggest customers, or the economy crashes, you weather that storm with this reserve.
Second, you should set money aside to reach your strategic business goals. Whether that’s more marketing, new products, buying new technology, or simply investing in your existing products or services to increase your satisfaction. Whatever it is, set the dollar amount that you will invest in it, and leave that in cash.
Finally, you can pay yourself all that is left in your business. Any excess cash can be paid to you in a distribution or divided amongst your partners according to your respective equity in the business.
Okay, so now that you know how much to pay yourself, let’s discuss the methods to pay yourself. Like how much should be paid in salary, or in distributions or draws.
The Different Types of “Salary for Small Business Owners”
The characterization of your pay is very important for tax purposes, which we’ll jump into in a minute here. Let’s start by defining the different types of owner compensation.
What is W-2 Salary?
Salary is W-2 income. Specifically, wages that are subject to federal taxes, state taxes, medicare, social security, and so on.
What is an Owner’s Draw?
A draw is simply money you withdraw from your business. Think of a bank transfer from your business bank account, to your personal bank account.
You’re receiving money that has not been taxed.
What is an Owner’s Distribution?
A distribution is basically the same thing as a Draw. A draw is a type of owner distribution, which is distributing money from your business to yourself.
What are Dividends?
There are other types of distribution, like dividends. Dividends are how the shareholders of corporations distribute their profits to shareholders.
Dividends are the ways big corporations pay their shareholders, and aren’t really used for small businesses, so go ahead and throw that to the side for the sakes of this conversation.
The real question we’re trying to answer here is – how much should you be paid in owner draws vs. w-2 wages?
Owner’s Draw vs. Owner’s Salary for Small Business Owners
Now that the definitions are out of the way, let’s jump right into it.
What is the best method of compensation for small business owners? W-2 Salary or Owner Draws/Distributions.
The answer to this question ultimately depends on your entity structure.
For example, sole proprietors, partnerships, and LLCs are taxed on all of their profit, regardless of whether cash is distributed or not. This is referred to as “pass-through taxation”.
With this in mind, one might say that there is no “tax” reason to pay yourself a monthly salary. You’re going get taxed on all of your profits, so it’s better to pay yourself something so you can pay your tax bill, right?
Why you may elect to pay yourself a W-2 Salary from your Small Business
Tax-aside, there are legitimate “business” reasons to pay yourself a salary.
For one, you should budget a salary to replace you in the event that you are no longer working in the company. What if you want to hire a CEO to run the company without you? Or, what if something tragic happens to you and you can no longer work?
If your business is not profitable in a scenario where you cannot work in the company, then that is a severe business risk.
For example, let’s say you have 15% profit margin in your business. But that does not include your compensation, which you equate to be, idk, $150,000.00.
If you budget an extra $150,000 in salary to your company, and the salary of all of your partners, you’re probably not going to be profitable.
And when it’s time to sell your business, or hire executives and managers, you may find yourself stretched for money because you did build this into your prices.
So what can you do to prepare yourself for this?
You can pay yourself a “reasonable” salary, or market-based salary for the work you do. Or, you may decide to not pay yourself at all but raise your overall profit margin. Or, maybe you’ll try to increase your net profit margin to 30% so you can build more room for executive compensation?
It’s all your choice. But you need to decide, and you need to be prepared for things like this to scale your business.
So then, when does it make sense to pay yourself a W-2 salary?
Paying yourself a salary makes sense if your business is a corporation.
Specifically, for S-Corporations, you must pay yourself a salary for the services you perform for your company.
This is because distributions to owners in corporations are only subject to federal and state tax, not medicare and social security taxes.
Whereas in LLCs or partnerships, the government does collect “medicare and social security taxes” hypothetically, through the self-employment tax.
As you can see, your entity structure largely determines your overall tax liability, and if you need help navigating this, then we’d be happy to help you craft a tax plan.
But that aside, in corporations, a good rule of thumb is to pay yourself a salary for the work you do, and you get distributions based on the profit you own.
As long as you do this, you can stay out of trouble with the IRS.
Here’s a quick recap of the major takeaways from this post:
- How much should you pay yourself from your small business? In short, you should have 3-month of operating expenses and money set aside for your strategic goals, then pay yourself everything that’s left. You’ll need to carefully track your expenses on a monthly basis and craft a budget in order to do this.
- What are the best methods to pay yourself? For pass-through entities like LLCs and Partnerships, it may be best to pay yourself through an owner’s draw. For corporations, especially S-Corporations, you are required by law to pay yourself a reasonable salary for the work you perform for your organization. If you do not, you’d be evading certain taxes like medicare, social security, or self-employment taxes that other entities face, and could be penalized as a result.