One of the most important wealth building concepts for entrepreneurs to master is to “pay yourself first.” This advice is often “lost” in the midst of struggling to pay everyone else in a small business, but it is critical to your financial success.
How Much Should You Pay Yourself?
This isn’t an easy question and there aren’t any absolute answers. Some owners pay themselves a moderate amount during the year and then add in a substantial bonus based upon their company’s profitability at year-end. Others take a salary comparable to what they think they’d have to pay someone else to do the job. But many owners don’t really pay too much attention and just take random payroll checks (or “Owner’s Draw”) on an ad hoc basis as they need money for personal expenses.
So What Should You Do?
Be reasonable. Try to set a pay scale that is justifiable for your position based on the local employment market and to cover your personal cash flow needs. If you’re completely in the dark on this, you can research sites such as Salary.com to give you some basis for comparison.
You’ll need to take into account your own cash flow needs, your business’ profitability and cash flow, the type of entity you are (Sole Proprietor, C Corporation, Sub-S Corporation, etc.), and whether the IRS is likely to agree with the salary amount if you are audited. (Your tax accountant can give you some advice about the last item.)
If you’re a Sub-S, your compensation will be taken as a combination of salary and Sub-S dividend distributions. Be realistic about the amount that is taken as salary vs. the amount that is taken as distributions. From a personal tax standpoint, the difference is that you don’t pay employment taxes on distributions as you do on salary. As the business owner, this tactic “saves” you almost 15% in employment taxes. However, the IRS takes a dim view of owners who don’t take reasonable salaries and report overly large Sub-S distributions instead. This is an area of interest for the IRS, so owners be reasonable and have some justification for the amount of salary that you draw.