As a small business owner, you run a business to create something, but you also need to support yourself.
So deciding what to pay yourself is a difficult question; it’s mired in personal, tax, and financial considerations.
Let me lay out these considerations for you.
Personal considerations
For many small business owners there’s a delicate balancing act when it comes to compensation. You need to take enough to cover your personal living expenses, but you want to leave as much as possible in the business for reinvestment (e.g., hiring more staff, buying more equipment, and doing more marketing) to help it grow.
I know one business owner who was struggling to meet payroll and other business expenses so he took no salary. In fact he took a job as a night short order cook as a stopgap measure (only about a month). He did this to cover his personal expenses without having to lay off workers or make other cuts that he thought would hurt the business in the long run.
Tax considerations
What you take out each week, month, or at other times is more than just a number … it has implications for both income and payroll tax purposes.
- If your business is incorporated, then you take a salary. You pay personal income tax on the salary; the corporation deductions it. The salary is subject to payroll taxes (FICA for both you and the corporation; FUTA taxes for the corporation).
- If your business is unincorporated, you aren’t an employee with a salary; you take a draw. You are taxed on your share of business income without regard to what you do or do not take out of the business. Your draw is not deductible by the business.
The numbers can be the same whether you take a salary or a draw, satisfying your personal needs, but keep reading to see what other considerations come into play.
Reasonable compensation. If you’re incorporated, the IRS insists that you take reasonable compensation for the work performed. This means that if you’re a C corporation, you can’t inflate salary merely to create a larger deduction for the corporation. And if you’re an S corporation, you can’t minimize compensation to lessen payroll taxes. Until now, many small business owners pegged their compensation to the Social Security wage base (e.g., $128,400 for 2018); this may change.
20% qualified business deduction. There’s another consideration … the new 20% qualified business deduction for pass-through entities (S corporations, partnerships, limited liability companies, sole proprietorships), which applies for 2018 through 2025. The deduction applies to qualified business income. But there’s an important limitation tied to W-2 wages (all wages, not merely the owners’) … so more wages mean a larger qualified business deduction. There’s another limitation … for specified service businesses. Owners of these businesses are barred from a deduction if their taxable income is too high, so the amount of wages for these owners is meaningless for purposes of this deduction. Complicated? You bet.
Financial considerations
Financial statements, such as your balance sheet and profit and loss statements, are vital to your business. They are the basis on which you can obtain financing. And if you’re thinking about selling your business, financial statements are used by potential buyers to decide whether to acquire your company. Creating financial statements that look good entail careful thought about what wages do to them. What will higher compensation to you do to our P&L statement?
Summing it all up
What appears to be an easy question — what to pay yourself — has a complex answer that varies from owner to owner. Best idea: Sit down with your CPA or other tax and financial advisor to work through all of these considerations and decide what the right compensation is for you.
