Don’t you wish entrepreneurs could have an open and honest conversation about business owner salary?
If they did, here’s what it would probably sound like.
“I pay myself a minimum wage.”
“I take just enough to cover my basic needs and reinvest the rest.”
“I don’t have a set number. It depends on the month/year/how I’m feeling.”
Let me start by saying that deciding on the right business owner salary can be tough. In theory, everyone agrees that they should get compensated for the work they do and the risks they take. In practice, business owners often refuse to take a proper salary from the company, because taking a salary feels like they are draining growth potential from the company.
Ready for some good news? Agonizing over your business owner salary is optional. There are many reasons why a business owner should get a proper salary. Even better, getting this right can be a tremendous benefit for the business. And it all starts with taxes!
Business Structure and Owner’s Compensation
The way you have structured your business will play a big role in how you can get paid.
Some businesses compensate the owner through what’s known as “owner’s draw”. If you have a sole proprietorship, a partnership, or an LLC, you can’t take a conventional “salary” from the business — you get an “owner’s draw” instead. Owner’s draw is subject to the balance is the owner’s equity account. In turn, taxes are based on the owner’s share of the business profits, not on how much (or how little) each owner chose to “draw” from the business.
If you are running an S-Corp, you have the option of taking a salary and distributions. And, if you have a C-Corp, your compensation options include salary and dividends. For the purposes of this conversation, let’s focus on business owner salary piece.
What Does the IRS Say About Business Owner Salary?
The IRS can take a special interest in business owner salary for several reasons. So, since nobody likes special interest from the IRS, let’s look at this from the tax perspective.
Salaries and wages paid to employees are a tax-deductible expense for the company. Employees report those salaries and wages as income and pay taxes on it at ordinary income tax rates. Keep in mind that if a business owner gets a salary, he or she falls into the same camp as other employees. Distributions and dividends to partners and owners get different treatment as far as the IRS is concerned.
If you have an S-Corp, you are working with what’s called a pass-through entity. That means your S-Corp doesn’t have an income tax bill. Any income is passed on to the owner(s). In this case, the owner can get a salary and withhold self-employment taxes from the paycheck. They can also get distribution out of the earnings that have previously been taxed at the owner’s personal rate. That allows the owner to get some compensation without having to pay self-employment taxes.
If you have a C-Corp, any dividends paid from the company to owners or shareholders are classified as capital gains. That calls for a lower tax rate and potentially a lower tax bill to the IRS. So, the IRS can raise a red flag any time the owner appears to take a lower salary but makes up for it with dividend distributions. In those circumstances, the IRS has the power to reclassify dividends or distributions as wage payments. If that happens, the payments are taxed at higher ordinary income tax rates (Section 7436, Rev. Rul 74-44).
Bottom line: If you are running an S-Corp or a C-Corp, the IRS wants you to get a reasonable salary from the business — because it affects their revenue.
If you are curious about how the IRS determines if compensation is “reasonable,” the agency has published a list of factors to consider[1]. Those factors include: the owner’s training and experience, his or her duties and responsibilities, whether a pre-determined formula is used for compensation, the company’s dividend history, and more. If you are looking for an estimate, it is common practice for business owners to pay themselves a salary of about 60% of business profits. That number is only an estimate, though.
The main takeaway here is that the IRS wants to see a reasonable business owner salary! The agency provides some guidance in determining the proper amount of compensation, but other factors can come into play as well.
Choosing a Salary: What’s the Right Number for Your Business?
Determining the salary for a business owner requires you to do the legwork. The right number is different for each business, so work with a trusted consultant or advisor.
The first step is to think through two important questions. Each one may offer different insight into the answer, so you need to answer them both.
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- “How much would I expect to be paid if I was doing this job for someone else?” This mindset can help you detach from the emotional aspects of being a business owner and think through this objectively.
- “How much can I be paid without negatively impacting the company?” To answer this, one must consider the company’s long-term goals. Think about your plans to spend on big-ticket items, like equipment, technology, or opening a new location. It is also a good idea to build a budget, run a projection for the next 2–5 years, and include your potential salary in that budget. You can do this in Excel or ask an advisor to help you build a more complex, interconnected model.
In our experience, drawing a business owner salary can sometimes trigger a sense of guilt. It is important to acknowledge that and to separate your feelings from the business decision you are trying to make. You deserve to be paid throughout the year for your efforts. Building a reasonable salary into the business budget can also help you move toward a sustainable business that is not overly reliant on you.
Look to Others for Guidance
Unfortunately, there is not a simple answer or formula to determine how much to pay yourself as a small business owner.
One method is to look at the salaries of other small business owners. Do you have business owner friends you can talk to? Are there local clubs or organizations, like your local Chamber of Commerce, that can expand your network? Ask your financial advisor or accountant for their thoughts. These professionals often work with other businesses in your area. They may have insights about what other companies are doing.
Another method is to review national and local salary averages for business owners. According to a study by Payscale[2], the average base salary for small business owners is $67,140. For owners with no experience, the average salary is $35k, and for owners with over 20 years of experience, the average is $77k. Again, these are averages — which may or may not apply to you depending on the type of business you are running. Also, the numbers quoted above only reference base salary. There isn’t a way to tell how much those owners got over and above the base salary in benefits, distributions, and other incentives.
Business Owner Salary: Paying Yourself First
Determining the correct business owner salary can be difficult and stressful. You must understand the IRS rules, consider the overall health of your company, and factor in your personal financial situation. The good news is you don’t have to figure this out yourself. The emotion and stress of running a business often keeps business owners from thinking rationally about their own salary. Ask others for advice and counsel. Our team of experts here at TreMonte is available to assist as you work through this important decision. If you are uncertain that you are doing this right, reach out to our team at TreMonte Financial.
[1] https://www.irs.gov/pub/irs-news/fs-08-25.pdf
[2] https://www.payscale.com/research/US/Job=Small_Business_Owner/Salary
Featured Photo by Igal Ness on Unsplash