Many business owners don't think to pay themselves a salary in the beginning of their business. As the company grows, they may take a small subsistence salary. But later, as the company becomes more profitable, they may draw out larger amounts as a significant measure of their success. Unfortunately, they may also unknowingly mix compensation as the owner with that of also being an employee.
So what is the correct compensation for a business owner? Well, it's complicated.
Pay for the Position
In the beginning, many business owners may pay themselves enough to meet their personal financial obligations. This doesn't mean that it will be as much as they made at their job before starting a company, but it can be enough to pay their bills.
Consider doing a budget and a cash-flow projection to ensure this can happen at the start. If the company can't afford an owner's salary, it may be time to reduce overhead and examine other expenses to make this happen. Remember: Not getting paid makes the company a hobby, not a business.
As the company grows and becomes more financially stable, business owners typically pay a salary that matches the worth of the job they are doing. One way to determine what that would be is to ask what would they pay an employee to do their job. Resources like Glassdoor can be a helpful starting point. However, Mike Michalowicz, author of Profit First, warns that “Your pay should not be the least you can get by with. Instead you should determine what salary supports your lifestyle, then back calculate what your company needs to consistently earn to support your salary. It is important to pay yourself, as the owner, fairly and well because if you don't it will only be a matter of time before you start to resent your business."
—Mike Michalowicz, author, Profit First
When the company is producing a large profit, the business owner may want to secure a salary that is a “premium" for being an owner. For example, if they would pay an employee $50,000 to do that job, the owner may make a salary of $100,000.
Regardless of the business stage, I recommend that the owner should be careful and not pay themselves a salary greater than 400 percent more than their best employee, or 5 percent of overall gross revenue. Remember that the owner's salary can be lower and then increased with additional compensation from profits.
It may not be the best idea for a business owner to borrow money for their company to keep their compensation at its current level. When the business hits an economic downturn, some owners “defer" their salary. This may be a good idea to manage cash flow, but I suggest not treating it as a liability on the balance sheet. Instead, consider reducing compensation until the company is profitable again.
Pay for Retirement
Business owners may want to contribute to a retirement plan because they will not have a pension at age 65. Some retirement plan contributions in the form of a 401K, IRA, or SEP are based on how much salary is paid depending on the corporation type. As a result, taking a very small salary might limit contributions and retirement savings for the owner.
Pay for the Profits
Business founders typically get a large percent of the cash profits. However, part of it it usually retained in the company to support growth. Most small businesses are structured as an LLC or S corporation where all taxes on profits are funneled through the owners' personal income taxes. That means, regardless of whether cash profits are drawn out of the company, the owners will need to pay tax on them. In many cases, the company issues additional cash compensation to the owner to cover the overall tax.
You may want to check with an accountant for the exact tax considerations for the most effective way to disburse all compensation. The IRS requires owners to earn reasonable and regular salaries, which means they can't earn all their money through lower taxed profits that can be disbursed without paying FICA (Social Security and Medicare). The IRS suggests choosing an amount similar to what another business would pay someone to do that job.
In the final analysis, one way to effectively know how much an owner should pay themselves is to review their financial statements monthly. These documents show the exact income, expense and changes in cash for the business. Many owners have their accountant review all their compensation and compare it to the financial health and outlook for the company on a quarterly basis.
How do you determine how much you take out of your business?
Read more articles on cash flow.