What To Know About Paying Yourself as a Small Business Owner
It’s an interesting and popular question. How to pay yourself as a small business owner? The answer to that question is, “It depends.” There are a lot of variables to look at to find a system that works for your situation.
It’s funny we can always figure out what we’re going to pay an employee, but as small business owners, we have a hard time figuring out what we should pay ourselves. Not that there isn’t’ a method we can use but more of determining the worth of your work and the value you bring to the business.
This post will focus on tips, insights, and ideas to help you develop a fair system that works well for you. Near the end of this post, I have included a unique collection of resources created by various authors to give you an overall understanding of how and what you should pay yourself as the owner of your own business. Before you reach the resources, let’s go over a few key ideas.
How Do Small Business Owners Pay Themselves?
Depending on how your business is set up will determine how you should pay yourself. We will go over each method briefly, but first, some food for thought.
In my opinion, this is an advanced topic, and to get it right, you should consult with your accountant and your lawyer.
You don’t want to set up your company without the advice of a professional. Will you be able to do it? Yes, you can. You can set up your own LLC or corporation.
There are hundreds of resources that allow you to do this but do you want to take the chance of missing something? One mistake can cost you in taxes and liability. Another advantage is when you talk to a professional, they can advise on the best solution for your operation. For example, it may be best to start as a sole proprietorship and incorporate it later.
Methods of Payment as A Business Owner
There are three methods to pay yourself when you own the business or own shares in an LLC or a corporation. Naturally, some of the rules and regulations will differ depending on where you operate your business. Let’s say you operate a business outside the USA. You have to look into the law and regulations in that country to ensure you are compliant. Let’s briefly go over the methods you can use to pay yourself.
Method One Is Called a Draw:
When you transfer money from your business account to your personal account, it’s referred to as a draw. When you use this method, no taxes are deducted. In other words, you transfer money from your business to your personal account. Each draw you take is considered part of your personal income, and you are responsible for paying that tax when you file your personal income tax.
If you take a draw, I would take off, for example, 25% and put it in a separate account, ensuring you have that money available when you have to pay your taxes.
Suppose over the year you have withdrawn $100,000 to your personal account and you haven’t set your tax portion aside, you could be liable for thousands of dollars that you don’t have because you spent all your money.
That’s a situation you want to avoid. It’s to your advantage to consult with a professional accountant and plan for a strategy that works well for your personal finances and works well for your business.
Draws are used when you have a sole proprietorship and, in some cases, an LLC. Some LLCs, and all sole proprietorships, are taxed as your personal income instead of a corporation that is a separate entity.
Method Two Is Called a Distribution:
A distribution is similar to a draw. With a distribution, you take your percentage of the profits. A distribution is used when there is more than one partner in an LLC.
Method Three Is a Salary:
When you own a corporation, you and the corporation are separate entities. The corporation will pay you a salary, W-2 income subject to state and federal taxes, as well as medicare, social security when applicable.
Paying Yourself as a Sole Proprietorship
How To Pay Yourself As A Single Member LLC
How To Pay Yourself As A PartnerShip LLC
How To Pay Yourself As An LLC Taxed as an S-Corp
How To Pay Yourself As A Corporation
Should I Pay Myself a Salary from My LLC
The common question is, “Should I pay myself a salary from my LLC?” It all depends on how your LLC is set up. If it’s set up as you are the sole owner or have partners, it will make a difference.
If the tax structure is set up as an S corporation tax classification, you’ll have to pay yourself a salary for tax purposes. You can also withdraw profits as a distribution.
Again as mentioned in the previous section, I advise on getting advice from a professional.
What Is the Best Way to Pay Yourself as a Business Owner
Waiting Until Your Business Is Strong and Profitable
Some business owners don’t even pay themselves. Depending on the setup of your business and If you can afford this, that’s the way I would go until the business is stable and making a profit. The profit should be enough to support the business, pay all monthly expenses and allow you to put a percentage on the side for expansion and an emergency fund.
Suppose you want to take an extra step and be safe. Build a cash reserve consisting of three months of operating expenses. A cash reserve fund will allow you to sustain any unexpected hardships that come your way. It doesn’t guarantee success, but it will help you get through a storm.
Once you have all the above in place, then that’s a good time to start paying yourself.
Can You Pay Yourself?
Unfortunately, many business owners can’t wait for a cash reserve if they don’t have enough money to support themselves in their personal lives. They need the business to support them so they can operate the company full time. Otherwise, they have no personal income.
You may have heard the term, “pay yourself first.” When you have an income, you will focus on running the business instead of making ends meet regarding your personal finances and running your business.
This point is something you should consider before you start a business. Does your business plan include paying you a salary? If the business can’t support itself and can’t support you, you will have a hard time running it. You may need to change your plan.
Don’t Overpay Yourself
You are in business because you’re doing something you like, or you want to improve your financial situation or want to be the boss.
All the above reasons are valid and valued by many people.
What you want to avoid, especially when starting, is living the life you’ve dreamed of by paying yourself too much. Sometimes a business hits the jackpot as a startup and will see a great deal of cash. Most businesses struggle with cash in the first few years, and if you pay yourself too much, you are destroying your chances of succeeding in the early stages.
Another way is to pay yourself a comparable wage. If you hired a manager, what would you pay them? You could pay yourself the same amount or a little bit less.
One of the problems you may encounter is your business may not support the wage of a manager. So you may have to take a wage cut or look at the minimum wage for a manager.
The key is being able to run your business without having to worry about paying your living expenses. You can take enough to cover your expenses and leave the rest in the business.
Once your business starts to gain traction and become stable, you can increase your wage. In the beginning, keep your cost down as much as possible because one of the main reasons a small business fails in the early stages is because the money runs out. You don’t want to pay yourself when your business is struggling for operating money.
How To Prove Your Income When Self Employed
If you’re looking to purchase a house, car, or looking for a loan, you’ll need to provide “proof of income.” As a self-employed person, you pay yourself, so what’s the best way to provide proof?
Being Self-Employed for Several Years:
When you have been self-employed for at least three years, you can provide “proof of income” by providing your tax returns. Most financial institutions will need at least two years of returns to verify your income. Anything less may be considered as high risk because you haven’t been in business long enough.
Being Self-Employed Under Two Years:
If you have been in business for under two years, it won’t be easy to get a loan. You would only be able to provide your latest tax return which would be only one year. You could provide your bank statement showing your earnings. Even with all this, the financial institution may require a co-signer to approve your loan.
Proof of Income Can Be Tricky
If you have a corporation and don’t need a large salary to live on, you may take a reasonable salary and reinvest the rest of the profits in the corporation.
Reinvesting your profits is a good way to grow your business while taking a moderate salary. If you apply for a loan with a modest salary, you might not make enough to qualify for a mortgage because of your low earnings.
You may need to give yourself a raise for a few months before applying for a loan to show you can afford the loan payments.
As mentioned earlier in this post, I have included resources written by various authors to give you a complete overview of paying yourself as a business owner.
Some authors will go into depth in their articles, while some will give you an overview. Even skimming the articles included in this post will give you a strong background in paying yourself.
In my opinion, it’s good to gain a strong understanding. I would speak with my accountant and lawyer to ensure I’m taking the best route for my business.
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