In the beginning, many small business owners receive no salary. However, as the business grows and becomes profitable, owners start taking money back. At that point, new questions arise. How much should you pay yourself? And at what point should you give yourself a raise?
One approach for the owner, at least in the early days of the business, is to take a salary that is just sufficient to cover basic needs. Starting with a personal budget for outlays such as housing, food, healthcare, clothing, and transportation, the owner can allocate enough of the business's cash to cover those expenses, and reinvests the rest into the business.
An owner should increase this base salary with annual or similar raises to reflect increases in cost of living, just as any employee would receive. This minimum base can be further supplemented with annual or quarterly bonuses if profits are sufficient and there is enough cash on hand that taking it out as a bonus won't harm the business.
Alternatively, instead of basing the owner's salary on living costs, it can be based on market rates. You can do this by finding out the average earnings of owners or CEOs in businesses in the same industry, in the same region, and of similar size. This information can be obtained from trade groups and from employment websites that include salary and wages.
Along with these common sense concerns, tax rules must be kept in mind. A sole proprietor who takes nothing in salary may draw the risk of having the business classified as a hobby by the Internal Revenue Service.This could mean that past expenses taken as businesses deductions could be disallowed, possibly creating a potentially significant tax liability.
Owners of incorporated businesses have more tax issues to keep in mind. An officer of a corporation is required by the IRS to receive wages that are generally commensurate with the duties the officer performs. This usually means paying yourself a market wage similar to what your business or one like yours would pay someone to do your job.
There are a number of other complex IRS rules covering how compensation, distributions, draws, and dividends are treated for tax purposes. Because of these complexities, it's absolutely essential that you discuss your plans for your salary and compensation with your accountant or financial advisor.
Investors also need to be considered. Investors and lenders generally do not want to fund a business that is only viable as long as the owner takes little or no salary. If you have been taking a very small salary, it may be advisable to demonstrate the business's profitability, stability, and long-term viability before approaching investors and lenders and taking a larger salary.
Finally, partners must be taken into account. A partner who is also an employee may feel entitled to earn as much or more than you, depending on the relative difficulty and value of the services each of you provides to the business. A partner who is an investor but does not work in the business may receive less, depending on the value and size of the financial support provided.
As the owner, you can raise or reduce your compensation to meet your personal needs or the needs of the business. If you're saving for a down payment on a home, you may want to increase your compensation. On the other hand, if the business is going through a rough patch, you may want to take a temporary pay cut to help out.
Whatever you decide to pay yourself, be flexible.
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