By Emil Abedian
Running your own small business means making lots of decisions. Many will be financial in nature – how to charge for your product or service, how much to invest in business development and what to pay vendors.
But, there’s one financial decision you might not think about at the outset: How to pay yourself. It’s a question worth thinking carefully about in order to keep your company finances clear cut and organized, while also ensuring that your needs are met.
When it comes to their own pay, some business owners might take a haphazard approach by cutting themselves a lump sum check from the business based on need. And while this may work just fine for some simple businesses, it’s not advisable for others. How you’ll pay yourself should be built right into your business plan. Here’s how to determine the best way to compensate yourself based on your organization.
Salary vs. Draw
There are a few factors to consider when determining your pay. The type of company you own, your profit and expenses plus reasonable compensation guidelines put out by the government will all play a role. Based on these, you’ll either pay yourself via draw, salary, or a combination of the two.
A draw is money you take out of the company for your personal use. You can do this at any time and the amount you take can vary based on how much you need. A salary, on the other hand, is a fixed amount of money taken from the business at regular intervals. So, you’ll decide on the amount and the frequency of each payment upfront.
Choosing the Draw
Sole proprietors, single-member LLCs and partnerships can not take a salary and so, by default, pay themselves with a draw.
If the aforementioned enterprise category applies to you, there are a few things to consider: Be sure when you take a draw to do so only from your company’s profits or from capital you previously invested. If your business has a sudden influx of cash, it can be tempting to carve out a big chunk of that for yourself. But, basing your draw on revenue numbers instead of profit could put you at risk for not being able to cover your future expenses. You should aim to keep your draws relatively consistent in size.
Also, you won’t be withholding anything from the draws you take. You’ll have to factor that amount in to your quarterly estimated taxes and be prepared to pay self employment taxes including social security, Medicare plus federal and state taxes on every draw. This could range from 30-50 percent of your net profit before you compensate yourself, depending on which state you operate in and how much total profit your company generates.
Going with Salary
Many owners of S or C corporations and LLC’s who have elected to be taxed as an S or C corporation will pay themselves a salary instead.
Taking this route might seem simpler on the outset in that state and federal taxes are withheld automatically since you’re paid by check as an employee of the company. However, this means that you’ll also have to hire a payroll company and federal and state payroll tax returns will be due quarterly.
On the plus side, there’s no need to worry about personal quarterly estimated tax payments or paying self employment tax separately. When it comes to taking a salary, deciding on the right amount can be tricky. To do this, you’ll need to consider what is reasonable compensation for your position.
The IRS has established guidelines to ensure business owners’ compensation is commensurate with their duties and in line with what others in a similar role would earn. When they’re not, or if a business owner’s salary is completely out of sync with what their employees earn, it can raise a big red flag to the IRS – putting you at risk for an audit. You can and should allow for salary increases in your business plan and projections.
Don’t Forget the Perks
When laying out your plan, don’t forget that compensation doesn’t have to be limited to just a straight paycheck. There are ways to get creative and add more value to your package. You can do this in the form of dividends you collect quarterly, contributions to your retirement plan or even an annual bonus based on your company’s performance. Benefits like health insurance or a car allowance can also increase your total compensation package.
Before making a decision on what your compensation will look like, be sure you have a clear picture of your numbers and your company’s current financial situation. And with all the factors to consider, it’s worth consulting with a tax professional to determine what makes the most sense for your company as well. Once you make a decision, keep in mind that nothing is set in stone. You’ll want to revisit your compensation as your company grows and evolves to ensure it still serves you and your business well.