Is it okay to receive a salary from your small business? Of course, it is! So how do you decide what to earn? Here, you will learn how to decide what to pay yourself as a small business owner.
As a small business owner, how to pay yourself is something that you seriously have to think about.
After all, your business is probably your only source of income, and you went into business to make money.
But paying yourself first is also a controversial idea among some entrepreneurs.
They believe you should not take money from the business until it starts to be profitable.
In the meantime, you should reinvest all of your business’ earnings to grow it.
Even if you take the latter position, you still need to start earning money from your business at some point.
The question is, exactly when do you do so?
Paying Yourself – Now Or Later?
The main argument for why you should decide to pay yourself first as a business owner is simple – you need to eat.
You need to make money in order to pay for your basic needs.
In addition, you have to pay for other recurring expenses such as mortgage and car payments, as well as health insurance.
Ensuring that you earn enough from your business to meet your living expenses is even more important if you have a family.
As a single person, you might be willing to live the most simple and economical existence until your business starts to be profitable.
But it would be unreasonable to expect your family not to have a decent life until then.
On the other hand, the main argument for not taking money from the business at first is that you can grow it faster.
Since you are putting everything your business earns back into it, it will reach the break-even point that much more quickly.
When it becomes profitable, you can start taking a salary.
You might even pay yourself more than you would have received if you paid yourself at first.
If you live off your savings until you decide that you can pay yourself a salary, you may end up depleting your bank account before you start making money.
But there are some entrepreneurs who believe that you should save up in advance before you start your business.
According to them, you should have saved up enough to cover at least six months worth of expenses.
But, of course, this can be difficult since you are also raising money for your business’ startup costs and to cover its recurring expenses until it starts to make a profit.
This would make the amount you would have to save or raise more substantial.
Also, if you delay making money from the business you still have to decide at what point you will start to pay yourself as the owner.
Will you start when the business has reached its break-even point or when it actually starts to show a profit?
What about when you have already paid all your creditors and other financial obligations?
Or will you set a fixed period, i.e. six months to one year, before you start giving yourself a salary?
How To Decide What To Pay Yourself
When you decide to take money from your business, the next question is, how do you pay yourself as the owner?
When it comes to taking compensation from your business, you have two choices – salary or owner’s draw.
Owner’s draw basically means that you are taking funds out of the business for your own use.
These options affect the business in different ways.
If you choose to take a salary, this is considered a business expense.
So, it would be subtracted from your business profit.
For example, if your business earns a profit of $40,000 and you decide to pay yourself as the owner, a salary of $25,000, this would reduce your profit to $15,000.
On the other hand, the owner’s draws are taken out of the owner’s equity.
Cash or other assets that you contribute to your business are recorded as owner’s equity in your balance sheet.
Equity means that you have an ownership share in the business.
It also reflects your business’ true value.
In accounting terms, the owner’s equity is computed as ‘assets less liabilities’.
Assets are cash and other resources used by the business, such as inventory and equipment.
Liabilities are recurring expenses that you have to pay regularly as well as long-term debt.
If you take an owner’s draw, it reduces your owner’s equity.
For instance, if you contributed $50,000 to your business when it started, this amount is the owner’s equity. If you made a profit, this would increase the equity.
So, let’s say that at the end of the first year of operations, your business had a profit of $30,000.
This means your owner’s equity is now $80,000.
You can then choose to take some or all of the equity as your owner’s draw.
No matter how much you took as your draw, your business would still have to pay taxes on the $30,000 profit.
Of course, you personally would have to pay taxes on the amount of owner’s draw you took as well.
On the other hand, your $25,000 salary would reduce your business profit to $5,000. Your business would only have to pay taxes on the $5,000 profit.
But you would have to pay taxes on the salary.
Salary and owner’s draw are valid options only if your small business is either a sole proprietorship or a partnership.
If you have registered as a corporation, you will, of course, have to receive a salary or take dividends.
As the business’ owner, if you decide to pay yourself a salary, the major benefit is that you know how much you will receive on a monthly basis.
This will make it easier for you to budget not only to meet your basic needs but also for savings.
In addition, it will be easier for you to apply for credit since you have a steady stream of income recorded.
You will have to do all the accounting related to your salary or get an accountant to do it.
For instance, you will have to compute what income and other taxes you owe to the taxman.
Also, you will have to be familiar with tax laws regarding compensation, since you will have to set your salary at a level that does not violate tax rules and regulations.
If you choose the owner’s draw, you have more flexibility with how much you pay yourself.
You may simply decide to take out money when you need it.
Or you may choose to tie the amount you draw with how much money your business is making.
For instance, you can adjust how much you will take based on how your business is performing.
On the other hand, the owner’s draws make accounting more difficult.
Since the amount you take out changes, it makes it harder to manage your cash flow.
Although tax rules may vary among different countries, generally, owners have to pay self-employment tax on the draws they take.
Thus, here are the questions you need to ask when choosing between a salary and an owner’s draw:
- How will it affect the funding of your business? Which method will ensure that there is enough capital to meet business expenses?
- How much tax will you have to pay on it? What taxes will be due? You can consult with an accountant or tax lawyer to determine which method will incur the smallest liability.
How Much To Pay Yourself?
When you start drawing a business owner’s salary, deciding the exact amount can be challenging.
If the salary is too small, then you may end up struggling financially.
This could affect how you run your business since you are concerned with making ends meet.
On the other hand, if you pay yourself too much, you may affect the financial condition of your business.
Your salary will come from your business profits.
If it is too high, it may affect your cash flow.
If you choose the owner’s draw method, taking too much may result in not having enough equity to meet operating costs.
Here are some questions you can ask when considering the amount of your salary.
- How much do I need to meet my basic needs? You should pay yourself enough to get by so that you can focus your energies on growing your business without having to worry about paying your bills.
- How much am I worth? There are several ways you can answer this question. For instance, you can consider what a person in a similar business performing your job would be paid.
You can also consider what salary you should be paid given the duties and responsibilities you are performing.
- How much time am I devoting to my business? Since you are likely working more than the eight hours a day a typical employee is, you should be sure that you are being compensated for your time.
You can also take a more mathematical approach in answering how to decide what to pay yourself.
Do this by computing how much you need to live and what you are worth.
Step one is to create a personal financial statement.
Start by computing your basic monthly expenses for food, rent, utilities, and other recurring living expenses.
Make sure you include all expenses that are paid annually, quarterly and monthly
One consideration you might want to include is provision for an emergency account.
As a business owner who only earns income through his business, a sudden emergency can be costly.
You might be forced to take money from your business, which might affect its financial condition.
So be pro-active and consider putting aside a small amount now.
Then add any debt that you have to pay, such as credit card balances and car and home loan payments.
Make sure that you don’t leave anything out since this figure will be the basis of your business owner salary.
In order to reduce your living expenses, you might want to pay down as much debt as you can.
This will cut down your debt payments and save you money on interest.
Step two is to compute your basic worth.
There is a certain amount of personal consideration to this question since the answer comes down to how you value yourself.
But there are also ways you can quantify your worth.
First, compute what your market worth is.
Write down the amount of your annual salary less overtime and bonuses.
Then divide by twelve to get a monthly amount.
If you are not currently employed, you can use what you were paid in your last job.
But you should actually be paid more than your market worth.
As a small business owner, you have greater responsibilities and thus, you should be paid a premium above your market worth.
One approach to computing your basic worth is including the effects of inflation.
Take the current inflation rate and multiply it by four.
For example, let’s say your current salary is $30,000.
Divided by twelve, your monthly salary is $2,500.
If the current inflation rate is 3%, multiplied by four would give you 12%.
So, you have to add twelve percent to your market worth to get your basic worth, which would be $33,600 a year or $2,800 a month.
Of course, you can use any method you want to compute your basic worth.
What is important is that it is at least equal to your living expenses.
You chould also increase your business owner salary as your business grows.
This is only fair since, after all, your management is one of the reasons the business is doing well.
There are many ways you can compute this pay increase.
One suggested method is to tie it to your business growth.
For instance, if your earnings grow by 10% in the quarter after it reaches the break-even point, you can increase your base salary by ten percent as well.
Best Practices When Deciding How Much To Pay Yourself
Although you can theoretically pay yourself whatever you wish, you still have to be responsible for the money you take out of your business.
You have to strike a balance between drawing enough to let you live comfortably but without taking too much that could hurt your business.
Here are some guidelines you should follow for how to pay yourself:
- If you choose the owner’s draw method, make sure that there is enough capital left to allow your business to keep running.
There are several ways you can do this.
For instance, you can draw your original contribution in small chunks.
Or you can take out a certain percentage of the business earnings.
- Make sure you record any draws you take. This is very important, both for tax and accounting purposes. Not accurately recording the number of your owner’s draws might create confusion as to the actual financial condition of your business.
- Take tax regulations into account when setting your compensation. For instance, your country’s revenue service might dictate that what you pay yourself should be “reasonable” based on the standards of the industry your business is in.
- If you pay yourself first, you should make sure that it is enough for you to be comfortable – but not too comfortable. You need to leave funds in the business for the reinvesting in the business.
- If your eventual goal is to grow your business large enough to sell it, then you should limit the amount of compensation you take.
Put as much of the earnings of your business as you can back into it to grow it as quickly as possible.
Then take your payday when you sell your business.
- If you have employees, you might consider taking a smaller salary than them at the start. This could motivate them to work harder since they can see the sacrifice you are making. You will also have extra funds for reinvestment or additional staff.
- The owner’s draw should not be a substitute for an emergency account. One mindset that you should avoid developing is that since you can draw from your business at any time, you don’t have to worry about emergencies.
Your business is not a piggy bank that you can take money from at any time.
- Instead of taking compensation in cash, consider benefits that you can deduct as a business expense.
For instance, you can buy a new computer and charge it as an item of capital expenditure for your business.
If you use your car in your business, you can charge the mileage as an expense.
- Talk to a professional. Speaking with an accountant or other financial professionals can help you decide how much you should pay yourself. They can also explain to you the tax implications of whatever compensation option you choose.
Going into business means doing something you love.
But just because you enjoy what you do does not mean that you should not be well compensated for your efforts.
If your business becomes a success through your hard work and sacrifice, there is no reason why you should not reward yourself with a high salary.
However, you should also make sure not to get carried away and pay too much.
Have you figured out what option to settle for?
Which have you decided?
Do leave us your comments!
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