Business owners need to take money out of their companies to pay their personal expenses and reward themselves for their hard work. Deciding how much to take and how to arrange this depends on many factors: the type of entity involved, profitability, cash flow, options for alternatives to taxable compensation, and more. Here is a review of the factors to consider.
Type of entity
One of the confusing things for some business owners is clearly understanding the impact that entity choice has on compensation. In a nutshell (and somewhat oversimplified):
- If the business is incorporated, then an owner performing services for the business is an employee who can take a salary and other benefits. The corporation deducts compensation, which is subject to employment taxes. The owner reports the compensation as income on his or her personal return.
- If the business is unincorporated (sole proprietorship, partnership, limited liability company), there is no such thing as a salary. The owner can take a draw (a regular payment akin to a paycheck), but it’s not deductible by the business. There are no employment taxes on the draw; the owner pays self-employment tax on his or her share of profits, regardless of the amount of the draw. Note: An LLC can elect to be treated as a corporation for tax purposes and then make an S election so that the owner can receive a salary.
Deductibility
According to tax law, compensation is deductible only when it is reasonable under the circumstances. The tax law has 2 tests with respect to compensation for owners of privately-held corporations that are used by courts when the IRS denies a deduction on the grounds that the compensation is unreasonable; courts use one or the other:
- 5-factors test. This looks at (1) the owner’s role in the company (services being performed, personal skill, etc.), (2) an external comparison (a comparison to compensation by other companies to similar people performing similar services), (3) the character and condition of the company (size, complexity, general economic conditions), (4) conflicts of interest (the ability of an owner to designate a payment as compensation rather than treating it as a nondeductible dividend), and (5) internal consistency of compensation (whether payments are made pursuant to a structure, such as authorization by the board of directors).
- Hypothetical independent investor test. This looks at how much could be paid to an owner while still providing a hypothetical investor with a reasonable return on investment.
Payments to owner-employees may be something other than compensation (salary and bonuses), which are deductible by the corporation if reasonable. They may be:
- Dividends. These are nondeductible payments made by a corporation out of its earnings and profits. If a payment is called compensation but should be treated by the corporation as a dividend, it’s referred to as a disguised dividend. Sometimes this arises where the corporation pays some personal expenses for an owner. (The issue of dividends usually relates to C corporations, and not S corporations.)
- Loans. These are arrangements that give owners the use of money that should be repaid. It is highly advisable to formalize loans by using a promissory note setting forth the terms of repayment, the interest rate, and other conditions. If the loan has an interest rate below an IRS-set applicable federal rate (AFR) for the term of the loan, this creates “phantom interest” that is income to the corporation.
Practical considerations
Whether it’s a salary or a draw, disbursements to owners depend on some practical issues:
- Profitability. Business owners may scale their personal payments to how well the business is doing. In good times, there are good payments. In tough times, they may reduce or forego payments to help the business succeed.
- Cash flow. There needs to be cash on hand (or a line of credit to draw on) to make a payment.
- Employment taxes (an additional cost to salaries paid to owner-employees).
- Hours worked. SCORE reported that 39% of small business owners work more than 60 hours a week. Payments to owners may be tied to how much time they put onto the business (i.e., whether they work daily or are essentially investors).
- Impact on retirement savings (contributions to a corporation’s qualified retirement plan is dependent on the owner-employees’ compensation).
- Impact on the QBI deduction for owners of pass-through entities (i.e., businesses other than C corporations), where W-2 wages for owner-employees are an important factor in figuring the qualified business income (QBI).
Average compensation
According to PayScale, the average small business owner’s salary in 2023 now is $68,863. (At PayScale, you can input your location, skills, etc. and see the average in your location.) The vast majority of small business owners take home less than $100,000 and many take home nothing at all.
“Average” is a very general term, and compensation varies considerably by industry. Professionals, such as attorneys, accountants, and architects, and tradespeople, such as plumbers and electricians, in many cases earn more than boutique and salon owners. And location also affects the average.
Final thought
“You don’t get paid by the hour. You get paid for the value you bring to the hour”– Jim Rohn, American entrepreneur and motivational speaker
When it comes to the amount of money you take from your business, there’s no one-size-fits-all. The dollars must be tailored to your situation. Discuss your thoughts and concerns with your CPA or other tax or business adviser.
