Business is going well, and you’re finally pulling in more than enough revenue to cover your costs and take cash for your personal needs. The question is how do you set your salary as a small business owner?
The answer to this question may seem as simple as ‘Duh, I withdraw it from my small business account’ but, unfortunately, the reality is a little more complicated. As a business owner, you have two main options for taking home a salary and understand which option is best for you can have profound implications on your taxes, companies taxes and, ultimately, your company’s valuation.
What are my salary options as a Small Business Owner?
To pay yourself a salary or draw? That is the million-dollar small business question. The right option for you is primarily based on the legal structure of your business and your personal tax situation. Definition: A draw and a salary are both fine ways to pay yourself as the owner or operator of a small business. The primary difference is that a “draw” is an amount distributed from a sole proprietorship, partnership, or LLC without any tax deductions at the time of the draw. Whereas a salary is a payroll amount paid to you in the form of a paycheck with federal and state tax deductions, regardless of how you have filed your business entity. Read more about it here.
What should my small business do?
The fines for payroll tax errors are substantial enough to kill a small business. So, the first thing you need to do is speak with a qualified accountant or bookkeeper who will assess the revenue of your business, your personal income level, your financial needs, and the most recent legal changes to ensure you are paying the appropriate amount of taxes in the most efficient way possible.
Ok, I promise to speak with an accountant. But in the meantime, how should I pay myself a salary?
The main thing you need to do is investigate the different tax rules that apply to salary and draws, according to your business structure. If you are a sole proprietor, LLC or part of a partnership, you are free to draw the profits out of your business at any point. You won’t have to worry about payroll withholdings upfront, but you will have to pay the equivalent amount to the IRS when it comes time to file your personal taxes. Draws from corporations, in contrast, are treated as dividends and business owners are taxed both at the corporation level and again at the personal level. Small businesses won’t usually do this until they have gotten a little bigger, or unless they have a large number of shareholders. Regardless of your business structure, it’s important to note that if you pay yourself a salary, you will incur personal taxes, social security, medicare, and any relevant state taxes – and your business will incur the relevant payroll taxes also.
What other factors should I consider when setting my salary as a small business owner?
Remember what they say about death and taxes. The checks you’ll write yourself for a draw won’t take into account the taxes that are taken out of a regular payroll check. So there’s a real danger in rejoicing in the pre-taxed salary you deposit in your bank account and then catching yourself short when the taxman comes knocking. And he will come. Even if you’re taking money from the business as a draw, you are still obliged to pay the appropriate taxes and social security. Most business owners will need to take care of this obligation by making Quarterly Estimated Payments to the IRS.
Reasonable compensation for small business owners. When I started my business, I used to take draws because it seemed to make sense for me tax-wise. Then my accountant recommended that I start paying myself a salary – not a big one, but enough to satisfy the Internal Revenue Service (IRS). Because I was involved heavily in the day-to-day of running the business, the IRS deemed me as an employee also, so they expected to see me taking home a regular salary. As far as salary goes, the IRS requires you to earn reasonable compensation for the type of work that you’re doing. As a guideline, the IRS suggests that ‘reasonable pay is the amount that a similar business would pay for the same or comparable services.’ Mostly, the IRS wants to avoid a situation where you are ‘underpaying’ yourself through payroll and then making that up through draws. Again, a good accountant can help you interpret what’s reasonable for your business and can provide salary recommendations based on how you contribute to business operations.
Pay yourself enough. Regardless of the legalities and pursuit of tax efficiency, the important thing to do as a business owner is to pay yourself a salary no matter what happens – and on a regular basis. When I had my own business I made sure that I got paid when my staff got paid. Don’t sell yourself short. Taking care of yourself is part of running a better business. If the business you own cannot support you in a way that allows you to take home a regular salary, it (and you) won’t be around very long.
Consider your exit strategy. When you are ready to sell your small business, the potential buyer will want to know exactly how involved you were in running your business. They’ll also want to know how much they will need to pay someone to fill your previous role for them, and they will factor that in as a cost when they analyze your financials. By ensuring that you are paying yourself a salary on a regular basis, you’ll make it easy for them (and you) to get a clear sense of what the business costs to operate and what it is worth.
Special considerations If you are an officer in a corporation, you must legally be on the payroll and receive regular paychecks that include withholdings for Medicare, Social Security, federal income taxes, as well as any relevant state-level taxes. However, if your business is an S Corporation, you also have the option of taking an additional draw beyond your salary.
Remember, there’s no substitute for a professional advisor who can help you understand the unique situation of you and your business, so before deciding on how to pay yourself a salary as a small business owner, it’s always worth seeking out a qualified accountant.