Today marks the Carnival celebration of Mardi Gras, or “Fat Tuesday”. For those who observe, it is traditionally a time for merry making and indulgence before the start of Lent on Ash Wednesday.
We thought it was an ideal time to address an issue that many small business owners wrestle with: paying themselves. Many start-up entrepreneurs relish the chance to determine their own salaries. Seasoned small business owners often find that, in reality, doing so can be a complicated proposition.
Because business owners pay themselves from their profits rather than their revenue, it is a milestone moment when you are successful enough to be rewarded for your hard work. However, before you decide how much of a cut to take, there are a number of factors you will need to consider. These include your business structure, profits, expenses, and reasonable compensation guidelines.
Small business owners generally have two options when it comes to paying themselves: a salary and/or a draw. A salary is a fixed amount that you pay yourself on a regular basis. An owner’s draw or distribution is a portion of the profits that your business distributes to you as your payment.
What many people do not realize is that the legal structure of their business directly affects the way IRS views their tax status and, therefore, how they pay themselves. The following are some general guidelines, but it’s best to discuss specifics with your accountant before making any decisions.
Sole Proprietors and Partnerships
Sole proprietors and members of partnerships are free to pay themselves as much as they want from their business’s profits. If you are a sole proprietor, you and your business are considered the same legal entity. Under a sole proprietorship, profits from the business and your personal income are treated the same by the IRS.
In a sole proprietorship, your compensation comes from a draw payment. According to the Self-Employment Contributions Act (SECA), you must pay self-employment tax and estimated taxes on your income. It is important to keep the eventual tax bill in mind when determining how much of a draw to take. Many small business owners make estimated tax payments on a quarterly basis rather than waiting until the end of the year.
A partnership is different from a sole proprietorship in terms of operations, but to the IRS, these business structures are essentially the same. Partners are the same legal entity as their business, and any profit generated through a partnership is treated as personal income. If you are part of a small business partnership, you will take an owner distribution. Partnerships are pass-through tax entities, meaning the owners are responsible for paying their share of taxes.
In a corporation, the business is legally separate from its owners, and any profits generated by the business accrue to the corporation. If your business is organized as a C corporation, the law requires you to be on the payroll and receive regular checks that include withholdings for Social Security, Medicare, federal income taxes, and state income taxes as required.
Corporations are double-taxed, meaning the business is taxed and the business’s profits are taxed through each owner’s income. However, if your company is legally structured as an S Corporation, you receive wages and have the option of taking additional money in the form of a distribution without withholding the taxes that are taken out of a regular payroll check.
Before you start taking a paycheck, you must make sure your business is profitable and that it will retain enough of its profits to continue growing and operating efficiently. Some small business owners base their income on their business’s income, typically limiting their wages to 50% of the profits. When your small business cash flow is healthy, you can increase your pay. If you have less coming in than going out, you might need to lower your personal compensation.
Make sure all of your expenses are accounted for when determining your pay. You need to pay taxes and overhead like insurance and inventory, as well as wages, training costs, and benefits if you have employees. You are responsible for making sure your employees get paid before you pay yourself. Monitor your expenses regularly, and make sure any increase in overhead is taken into consideration when you are deciding whether or not to increase your pay level.
Reasonable compensation is the amount someone would be paid for similar work under similar circumstances at a different business. The IRS requires you to earn reasonable compensation for the type of work that you’re doing. This may depend on the size of your business, market sector, and level of turnover and profit.
Make sure you compare yourself to people who manage businesses of similar size, location, and industry. Consider asking owners of comparable small businesses if they are willing to share what they pay themselves. When doing your due diligence, ask yourself questions such as:
- What is your value to the business?
- Are your wages equal to the duties you perform?
- Do your wages take into account of your level of responsibility and the amount of business you handle?
- Does your pay seem reasonable when compared with your employees’ wages?
- What salaries do recruitment sites offer someone in your position?
The IRS website also provides detailed information and guidelines.
Pay Yourself What You Deserve
Ultimately, the amount you pay yourself will depend on the success of your business. The more money it brings in, the more you can expect to draw from it. For times when your business goes through a rough patch and you find yourself struggling to meet expenses or pay your employees, Summit Financial Resources can help.
We are transitional lenders who specialize in working with small businesses to stabilize their cash flow and avoid the cyclical ups and downs that can make it difficult for owners to pay themselves regularly. Our invoice factoring, asset-based lending, and inventory financing programs allow you to harness the cash in your accounts receivable to smooth out your cash flow so you can afford to reward your staff and yourself for your hard work, even during slow times.
Working Capital Financing is a few clicks away.
Summit Financial Resources specializes in working capital financing for small to medium-sized businesses that need increased cash flow. We provide working capital financing through invoice factoring, asset-based lending, inventory lending, and equipment financing.