Being your own boss, doing what you love – those are the big benefits of owning a small business. Paying yourself what you’re worth is often a challenge. You have a lot of bills – taxes, employee payroll, health care, business expenses, etc. – and, especially in the first few years, many small business owners are hesitant to take a salary. They live off their savings, earnings from another source, or just grab what they need from the cash register on a Friday night.
But, assuming your business is profitable, you should take a set salary. That salary should come out of your business’ profits, not your revenues. It should be a reasonable amount for the work you do, your location, and your industry.
One way to figure out what your salary should be is to figure out what you’d be paid if you were working for someone else. That should give you a ballpark figure. Whether you can afford to pay yourself that salary or not comes down to your numbers.
Doing the salary math
If you don’t have an accountant, you should have good accounting software. Either way, you want to look at your revenues over time, your anticipated accounts receivables for the next 12 months, and your accounts payable and other expenses. What’s left over? How much of that is available for your salary?
Don’t assume profits are all yours to enjoy as you choose. You should budget ahead for your business’ future growth. You need the right amount of working capital; assets that are liquid such as cash in the bank or can be easily liquidized, such as inventory and accounts payable. Tally up those assets – including what you can reasonably expect to have access to in the next 12 months and deduct the financial obligations that will be due within the year. Then divide your current assets by your liabilities to calculate your working capital ratio. In general, you want a ratio of 1.2 and 2.0 – anything under 1.0 is a predictor of serious business liquidity problems, while a figure over 2.0 suggests it’s time to put your money to work making more money.
When you have a good feel for your financial situation, you should be able to come up with a salary that makes sense – not too little, and not too much. Remember, even when you are paying yourself, your salary is subject to taxes. And as a business owner, you may be paying “double taxes” since you may have tax demands on both your business income and your salary. Talk to your account or a financial advisor to understand how to manage taxes. You should settle on a consistent amount but may want to have a discussion with your financial advisor on whether you should pay yourself a year-end bonus or give yourself raises when appropriate.
Draw or Salary/Distribution?
We’ve been saying “salary” throughout this article, but it’s more complex than that. Sole proprietors are paid via a “draw,” partnership owners get distribution payments/ guaranteed payment or, and S and C corporations pay owners a salary or distribution payments or both. How you pay yourself is important for tax reporting.
If you are a sole proprietor (or single-member LLC) you don't get a regular paycheck, you take a draw. No FICA taxes (Social Security/Medicare) are deducted, no income tax is withheld. You are responsible for managing those issues yourself.
If your business is set up as a partnership or LLC, you also do not get paid a salary. Instead, you take distributions from the profits, in accordance to the partnership agreement or LLC operating agreement. Note that if your business is a single-member LLC, you take a draw because you don’t have partners.
Are you the owner of a corporation or s corporation? If so, are you a shareholder or a corporate officer who takes part in the daily running of the business? Shareholders get dividends or profit based distributions; corporate officers get salaries. If for some reason, your small business is a corporation, you almost certainly have an attorney or accountant who can sort out financial compensation issues, which are frankly too complex to cover in this article.
No matter what type of business you have, before you make any decisions that could have serious tax implications, talk to an accountant or a financial advisor.
Perhaps your primary concern is not paying yourself a salary – instead, you need funding for your business. Unfortunately, owners of smaller businesses rarely qualify for bank loans – the application process is complex and demanding, and requirements are strict. You may not have the time, know-how, patience or credit history to qualify for the same financing options that were designed to meet the needs of big businesses.
One Park Financialworks to help owners of small and mid-sized businesses access the working capital that they need. Our process is simple and straightforward, and we’ve helped many small businesses who have been turned down by banks to access funding – even when the business owner doesn’t have a perfect credit rating. Visit oneparkfinancial.com or call 855.218.8819 to discover the options that make sense for you and your business.