As a small business owner, it’s all too easy to muddle together your business and personal lives. After all, in many ways, they’re one and the same thing.
But when it comes to your finances, keeping things both separate and exact is of tantamount importance — so much so that the IRS specifically recommends doing so for easier record-keeping and fewer headaches come tax time.
Of course, you still need to earn a living, so some of that money should end up in your personal account eventually. The following questions can help you understand when and how to start paying yourself a salary.
1. How long is too long to not generate a salary?
The question of when to start paying yourself is bigger than personal comfort and financial wellness. If you wait too long to pay yourself, the decision can have an impact on your overall business finances.
For example, if you end up needing to apply for a business loan, not generating a salary for yourself can make it look like your financial standing is weak — which may put your ability to qualify in peril.
Additionally, although it may be low on the priority list, your salary is a real expense that your company has to cover if it’s going to remain viable. Factoring in your salary as a running expense is the only way to accurately determine if you need to raise prices, make cuts or otherwise shift your overall business financial plan.
So as soon as you have sustained revenue and your books are in the black, it’s probably time to start cutting yourself a check. Keep in mind, also, that the specific means by which you pay yourself will vary depending on what kind of business entity you’re running — which we’re just about to get into.
2. How much — and how consistent — should your salary be?
Once you’re in a position to pay yourself, you have a whole new hurdle to jump: You have to figure out how much to pay yourself, along with when and how.
While there’s a decent amount of wiggle room for most small business owners in this regard, the specifics will look different depending on what kind of business entity you’re running. For example, in a sole proprietorship, you can take a flexible owner’s draw from your profits as business allows, whereas in an S corp, for example, you’d pay yourself as a W-2 employee with regular paychecks at a “reasonable compensation” rate. (More on the difference between an owner’s draw and salary in just a second.)
It can be tempting to pay yourself as little as possible — both to boost your profit margins and to minimize your personal income for taxes. But the IRS is wise to those antics, and if your wages are too low to actually pay your living expenses, it may look like exactly what it is: tax evasion. And again, if you’re ever in the market for business financing, lenders will want to see that your business is capable of sustaining its basic expenses — the owner’s salary included.
So sit down with your budget and take a real look at how much it costs to live your life. Your salary should cover that amount, plus enough so you can save for the future.
3. What’s the difference between the owner's draw and a salary?
Business owners can choose from two main categories when it comes to paying themselves: a salary and an owner’s draw. A salary is just like what it is when you’re working for someone else: a steady paycheck that involves a W-2 form.
Taking an owner’s draw is, essentially, cutting a check to yourself from the business profits for personal use as necessary. (This is different from an owner’s distribution, which is an agreed-upon percentage of profits split between partner business owners.)
An owner’s draw offers more flexibility, but the full amount you pay yourself will be subject to self-employment tax. A salary, on the other hand, offers (and requires) stability — but you can save some money on tax since self-employment tax won’t apply. Payroll taxes will, however — and when making these big financial decisions, it’s always a good idea to seek the advice of a qualified tax professional to make sure your bases are covered.
4. What are the long-term implications of not paying yourself?
So what happens if you ignore this article and choose not to pay yourself for an extended amount of time?
For one thing, as we’ve already mentioned, it doesn’t look great on your business’s expense sheet, which lenders will consider if you ever find yourself in need of business financing.
But it matters on a personal level, too: While your income doesn’t have an effect on your credit score, it does impact your eligibility to take out loans, as lenders will consider your income when assessing your risk level as a potential borrower. So if you’re in the market — or ever planning to be in the market — for a mortgage, auto loan, or any other kind of financing, you do want to have some income to report on paper.
Small business owners are privileged in their ability to choose their own salaries and change their compensation scheme as best fits their lifestyles and needs. Still, make sure your own salary isn’t actually the very last expense on your priority list. It’s important, and after all, you work hard to earn it.