(This post is part of my Small Business Startup & Survival Guide. You can catch up on the whole series here.)
You probably had two objectives when you started your business: to do something you loved doing and to make money. Often, the first part is far easier than the second part. But you need the second part because you need to eat.
Making money is a tricky concept. Revenue is not profit. And profit is not necessarily salary. What is coming into the business doesn’t always end up in your pocket. You have expenses to pay for taxes, employees, health care, professional expenses, retirement plans and potentially, debt service. How do you figure out what you can take home? Consider the following:
- Look at the numbers. This seems obvious but before you decide how much to pay yourself, you need to have a firm grasp of the numbers. This means that your accounting needs to be accurate and it needs to be contemporaneous. Dollars change quickly in business.
- Look at the numbers over time. Again, this seems obvious but is often overlooked. You need to know not only what you have in your bank account but what to expect coming down the road. Accounts receivable, for example, are good to know but they don’t equal available cash. Don’t forget about budgeted expenses like estimated taxes and debt service when figuring out what should be available to you. You’ll need to plan ahead before dipping into your accounts.
- Consider future needs. Need more space? Have a great opportunity to expand your product line? Those needs may affect how much you’re willing to take out of your business versus what you want to keep in the business. But don’t overextend yourself. Remember, you gotta eat. That fancy new office space can wait.
- Think about tax burdens. Whether you’re taking money out of the business as wages or draws, it’s subject to tax. If you take out more than you need - and have to return it - you don’t get a refund from the government. Similarly, depending on your choice of entity, leaving money that you could use inside the business can subject the funds to tax at the corporate level and again when you finally take it out (that’s the “double tax” I’ve addressed earlier in the series). That’s why planning is key. Think of yourself as the Goldilocks of the business world: you’re trying not to take out too much or too little, you want it to be just right.
- Whatever you decide to do, be consistent. While your business will ebb and flow in terms of revenues and expenses, try to pay yourself on a regular basis. You might be tempted to take more out when there’s more coming in, but remember that could change next month. Getting paid consistently lowers your own personal stress level at home (mortgages and rents don’t vary from month to month) and helps you figure projections. It’s difficult to know how much you or your business “made” when you’re dipping into your accounts randomly.
- Keep in mind that you can make changes later. I know, it’s confusing because I just said to be consistent. But it’s also important to be flexible. Your business could change - hopefully for the better - or your financial circumstances could change. You might land a big client or get an infusion of cash from an investor. When the numbers change at your business, check with your tax professional about whether you should make a change in what you take home. It may be that a raise is in order or maybe a year end bonus.
When you finally decide to pay yourself, how do you know how much to take? The answer: be reasonable. It’s hard to figure what reasonable compensation is but the Internal Revenue Service (IRS) has an idea of what they would expect. So do banks and financing companies. And trust me, you care what all of them think. When trying to figure what’s reasonable consider the following:
- What is it that you do? Yes, it feels like an easy question but for compensation purposes, there’s a difference between cashier and company president.
- What were you paid at your previous position (assuming that you’re doing something similar now)?
- What would you get paid if you were working at another company doing the same job?
- How often do you work?
- How big is your business?
- Where are you located?
The last two questions are important because size matters, as does location. When determining what would be reasonable, for example, you can’t compare the salary for a tax lawyer in a New York City white shoe/AmLaw 50 firm with the salary for a tax lawyer in a small Chester County practice. Even if you do the same work, the numbers aren’t comparable.
It's also extremely important to consider your business entity. Not all businesses are created equal. How much you can take out - and how - may be subject to federal and state laws, as well as any agreements that you might have:
- If you’re a sole proprietor or a partner, your compensation may come in the form of a draw or a distribution made to you. How much you take out and when is generally up to you (and/or your partners) and you have no fiduciary responsibility to shareholders or others.
- If your business is a corporation (no matter whether it’s a C corporation, S corporation or an LLC) and you are considered an employee, you should be taking out some form of salary (yes, subject to withholding). It should be considered reasonable under the facts and circumstances.
- If your business is a corporation (no matter whether it’s a C corporation, S corporation or an LLC) and you are not considered an employee and act only as an officer and have no compensation agreement in place, you typically wouldn’t receive a salary but would take a draw, dividend or other profit-based distribution.
- If your business is a corporation (no matter whether it’s a C corporation, S corporation or an LLC) and you are considered an employee and an officer (this tends to be the case for most), you have a number of choices: it’s often the case that you’ll opt to receive a reasonable salary plus a draw, dividend or distribution. This is a common practice especially with S corporations because of the flexible structure: the pass through form means that distributions to you won't be taxed at the corporate level. You should know that the IRS hates this arrangement - even though it's totally legitimate when done properly - and will watch very carefully to ensure that compensation is, indeed, reasonable. Why? Because draws, dividends or distribution are typically not subject to those pesky payroll taxes providing an extra tax savings for business owners.
You can - and should - also pay yourself in perks and benefits if you extend those same benefits to your employees. Those could include health care, retirement plans, cell phones for business use and other perks. Be sure to check to make sure there are no restrictions on paying yourself in perks and benefits before doing so: penalties for doing the wrong thing can be expensive. Check with your professional team for specific advice.
One final word: your business is not a piggy bank. Remember that your business, other than a sole proprietor, is a separate legal entity. That liability protection you were after? It only works if you act like a real company and that means observing corporate formalities. Playing fast and loose with the rules by, say, dipping into your corporate account to pay for your groceries on a regular basis offers the impression that it’s not a separate business after all. That could come back to haunt you in a lawsuit or other disagreement. You may also have a fiduciary or other legal duty to shareholders, investors and creditors who will not be pleased to find out that company money is being spent on personal expenses. Who else cares? The IRS. Paying for personal expenses out of company money is prohibited and could result in an adjustment to your tax bill.
