The topic of minimum wage is in the forefront to ensure that workers receive adequate compensation for the services they perform. For small business owners, the question of adequate compensation goes beyond any minimum amount. Obviously, business performance—profits and cash flow—dictates to a large extent what is affordable for owner compensation. But there are many factors that go into the decision on personal compensation.
If your business is incorporated and you work for it, you are an employee who can receive a salary. The salary is deductible by the corporation and taxable as ordinary income to you. It is also subject to payroll taxes. As a rule of thumb, it costs a business about 1.25 to 1.4 times the salary when factoring in payroll taxes. For example, a salary of $100,000 costs the business about $125,000 to $140,000. The figure varies with the amount of benefits provided, such as health coverage, retirement plan contributions, personal use of a company vehicle, and other perks.
If your business isn’t incorporated—it’s a sole proprietorship, partnership, or limited liability company (LLC)—you are not an employee. You do not receive a salary. Instead, you can take a “draw,” which is a distribution of money from the business. The draw is not deductible by the business or taxable to you; you pay tax on your share of business profits whether or not distributed to you. For example, for tax purposes a partner receives a distributive share of business profits and pays self-employment tax on this amount, regardless of what is actually paid out. Generally, distributions to partners and LLC members are dictated by the terms of a partnership agreement or LLC operating agreement.
According to PayScale, the average small business owner’s salary now is about $68,000. (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.
Obviously, “average” is a very general term. Compensation varies considerably with the type of business. Professionals, such as 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.
Also keep in mind that to obtain “average” means that many small business owners take compensation considerably higher than the average. This is so considering that so many owners don’t take any salary.
There are a number of tax considerations in setting compensation:
- IRS challenges. Only compensation that’s viewed as “reasonable” is deductible by a corporation. For C corporations, the IRS has routinely looked at this deduction category to verify payments to owners are reasonable in view of various factors (e.g., the work performed, the company’s profitability). Excess compensation (amounts that aren’t reasonable) may be dividends, which aren’t deductible by the corporation but are still taxed to owners. For S corporations, the tendency over the years has been to minimize payments in order to save on employment taxes (remember owners are taxed on their share of profits so a deduction for salary to them is not as meaningful as in the case of a C corporation). The IRS has successfully thwarted attempts by S corporations to pay no compensation even though owners performed services for the business. It has been common practice to set compensation for companies looking to minimize employment taxes at least the Social Security wage base ($142,800 in 2021). Again, this may or may not be reasonable.
- QBI deduction. Salaries (W-2 wages) are an important factor in figuring the qualified business income (QBI) deduction for owners with taxable income in excess of limits (adjusted annually).
- Retirement savings. Owners of corporations with qualified retirement plans have their annual contributions based on their compensation.
Many small business owners work for not too much more than a $15 per hour minimum wage. If you take the average annual salary and divide it by 52 weeks, with an owner working 60 hours a week, the hourly rate is less than $22 (for those who work 80 hours a week it’s $16 per hour). Still, the opportunity to grow a business, work less hours, and earn more money is a big attraction for entrepreneurship.
Fundera reported that 92% of small business owners have no regrets about starting their businesses, regardless of the compensation they receive. If 2020 was a struggle and your income dipped or dried up entirely, let’s hope that 2021 is much better.