How Much Should You Pay Yourself if You Own a Small Business?A salary that’s too low could hurt you and your business in ways you never imagined.
Running your own business is challenging because there’s no straightforward template for many of the things you need to do; you’re on your own, making your own rules. Case in point: What should you pay yourself? There’s no single answer to how much of the business’s net income should go to your salary. You will need to find what works for you.
Pay frugally at first
The right salary will vary depending on where you are in the lifecycle of your business. What you pay yourself in the first year should look very different from your salary in year five.
When you’re starting out, business owners agree it’s okay — and probably necessary — to pay yourself frugally, especially if your business is struggling to make a profit. Ideally, you’ve started the business with a secondary source of income or savings you can lean on to survive with little or no salary.
“In the first year, you should allow yourself to pay yourself zero, or near-zero if that’s what it takes to get the business afloat,” said Alex Mann, co-founder of ClickTime. Rod Kelly, president of PetraCat, agrees. “In my case, I was not taking a salary for the first 16 months of getting my business going. Once we got to a point of general consistency in both revenue and expenses, I started taking a salary.”
The startup phase doesn’t last forever, and experts agree it’s best both for you and your business to pay yourself a reasonable salary as quickly and consistently as possible. In fact, once your business is out of first gear, it’s inadvisable to take no salary — your tax consultant can advise you on how the IRS views this practice. You could be setting yourself up for a tax audit if you pay yourself less than a fair wage.
To decide on an amount, think about how much you’d have to pay someone else for the services you’re providing.
The IRS defines “reasonable compensation” as what “would ordinarily be paid for like services by like enterprises under like circumstances.” Put another way, you need to value your skills, experience and effort and set your salary around the amount you’d need to pay to hire your own replacement. Pay yourself significantly less and you are undervaluing yourself. Paying yourself a lot more could be interpreted by the IRS or a future buyer of your business as unreasonable and unjustified compensation.
Dialing in the right salary may not always be easy. Katie Gilden, CPA, a business valuation expert and principal of Fiske & Co, has some guidance on how to approach this issue.
“Put together a budget for hiring an outside person with the same experience, knowledge, and qualifications. The budget should include items such as salary, payroll taxes, benefits, stock options, zero-interest loans, paid time off, discounts and other perks. A clear and concise job description helps pinpoint the owner’s duties.”
Think of the future
Paying yourself adequately is critical for a number of less obvious reasons. While many business owners might think there’s less risk in underpaying themselves, SageVest Wealth Management’s president and CFP Jennifer E. Myers believes scrimping on your salary will inevitably catch up with you.
If you set your salary too low, for example, you will need to replace the Social Security income that would have come to you in retirement (from higher social security payments during your working years). Also, if you offer benefits such as life insurance or a matching 401(k) plan to your employees, a low wage could lower your own participation.
Then there’s the future sale of your business to consider. “Something that few business owners think of is how the amount they pay themselves might impact a potential business sale transaction. If you’re paying yourself too much, the profit on your books might not be appealing. Conversely, if you’re paying yourself too little and you have to stay for a business transition, you could be setting yourself up to be undercompensated once you become a true employee,” said Myers.
The health of your business will influence your salary — and paying yourself a salary will help you understand the health of your business.
“You’ll never really know where you stand with the dynamics of your business unless you’re factoring all real expenses into account, including yourself,” said Mann.
RJ Martino, president of iProv, recommends looking outside your company for guidance. “Find an industry group and ask them about their typical fully burdened costs. They’ll give you benchmarks on salaries, expenses and rates to charge for your industry.”