To prepare for this post, I performed an online search for the phrase “how much should I pay myself?” I received a staggering 61.9 million results, clearly demonstrating it is a subject of much interest.
After reading some of the articles and accompanying comments, I discovered it is also a subject of much frustration.
While having the freedom to set your own salary sounds great in theory, in practice, many entrepreneurs find it is not all it’s cracked up to be. Determining how much to pay yourself, when to pay yourself, and where to get the funds to pay yourself depends on a variety of factors.
Let’s take a look at some of those factors now:
Start with Your Business Structure
When we question how much to pay ourselves, we are referring to the amount that will appear on our W-2. In some cases, you have discretion to determine your compensation; in other situations, the IRS tax form preparation process will set the amount for you. The determining factor is your company’s legal structure.
- Sole proprietors and single-person LLCs: Your compensation is equal to your net income as reported on line 31 of Form 1040, Schedule C (Profit or Loss From Business). This is your reported self-employment income. You will pay Social Security and Medicare taxes on this amount, and it is included in your overall income tax calculations. Because your compensation is the same as your income, there is no formal paycheck in this setup.
- Multi-person LLCs: Considered partnerships, there is no salary involved; only guaranteed compensation in the form of payments and distributions. Again, you will pay Social Security and Medicare taxes on the amounts received.
- S and C corps: You have compensation options — as an employee (salary and bonus) and as an owner (dividends), or a mix. With the dividend tax rate usually lower than the combined income and payroll tax rate, there is a tendency to maximize dividends and minimize payroll. The IRS is alert for this practice, so tread carefully.
To provide “protection” if audited, you should calculate a “reasonable” compensation for your responsibilities and the amount of time you devote to the position. Research recruitment websites, newspaper want ads, salary surveys conducted by industry trade groups, and ask others in similar positions. Another “protection” is to pay yourself an amount up to the Social Security base so the government is receiving all its payroll taxes.
In a company where you are not the majority shareholder, the board of directors will typically determine your compensation based on comparable positions in related companies. It is a best governance practice for the founder/CEO not to sit on his or her own company compensation committee.
What to Pay Yourself With
You pay yourself with cash in the bank. Do not confuse this with sales. Sales are not the final amount of cash available. You are paying yourself out of the net balance, which is the amount left after you deduct all your expenses, such as rent, compensation for your employees, marketing, office supplies, travel, insurance, and IT.
However, even net income is not a satisfactory target. If you give your customers 30-day terms to pay, while the sale may have been made in April, you might not collect the cash until May or June. So cash receipts may lag sales. You can’t take a salary or keep your business running profitably without cash, so keep your eye on this target.
Depending on the maturity of your company and your plans for the business, you may adopt different compensation strategies.
- Start-up mode: It is typical for a start-up to be cash-flow negative in its early months, if not years. This results from one-time start-up expenses like buying equipment, building out a facility, stocking inventory, marketing to attract customers, building products or websites, legal and accounting costs, and rent and utility deposits. Also at start-up, there are no or few customers. As such, during these times, your compensation will be light as there are no funds to pay more. Hopefully, you had prepared a business plan, including a cash-flow forecast, so you knew the range of your compensation during this period, and if there was not enough to “live on,” you have made other arrangements.
- Lifestyle vs. ramp and sell: If you intend to own and operate your company for many years, which is what 95 percent of entrepreneurs plan, then you will want to develop, over time, a predictable compensation plan both to meet your personal needs and be predictable for yourself and the company.
However, if you are in the 5 percent who plan to start a company, ramp up products/services and sales quickly and then sell the business, your main reward will be when you sell. In this scenario, you will have very modest compensation during the time you are ramping up the company. The good news is that the sale of the company will probably be taxed at capital gains rates, which are lower than ordinary income and payroll tax rates. Of course, while this compensation plan applies to you and other owners, your employees will need competitive compensation and benefits to attract and retain them.
- Wait and see: Obviously, you need cash to pay compensation, and in a start-up or growing business, the cash on hand is often very unpredictable, so you need a flexible pay calculator. You can either pay yourself a percentage of cash profits, or you can pay yourself modestly during the year and a larger amount at year-end when you know the results for the year.
What to Do With the Compensation Received
Your compensation belongs to you and not the company. So first deposit the compensation received in your personal bank account. Then you can decide to use it for personal needs or reinvest in the company, which will take the form of providing equity or a loan.
What Am I Worth?
This is a good statistic to know as you have options to continue to work for yourself or join another team, but you will not find this number in any financial statement or wage report. Revisit the compensation information you found in your research for comparable positions. If your company does not have the cash resources to pay you this amount, you might consider working for someone else.
- There is less flexibility in setting one’s compensation than many entrepreneurs anticipate.
- Compensation strategies are different for startup vs. ongoing businesses, and for business that you plan to operate for many years vs. quickly grow and sell.
- You need a business plan with financial forecasts to know if will have sufficient cash to pay yourself a reasonable compensation
For more business planning tips on creating a business plan and key mistakes to avoid, you can view Hal’s other posts here.