Four steps for making one of the small business owner’s more challenging decisions: Determining your compensation.
When you worked for someone else, your salary supported your lifestyle and determined your Social Security and other payroll taxes throughout the year. You also worked hard to make the highest salary possible in your field. But as an entrepreneur, you’ll need to think differently about your personal income. Case in point: Did you know that 87% of business owners report earning less than $100,000 annually?1
As you collaborate with your bookkeeper or accountant on your business’ budget, keep an open mind about how you can reward yourself for all of those late nights, weekends, and holidays. Here’s how to start:
Step 1: Understand your compensation options.
There are two basic types of owner income:
- A distribution (aka a draw or dividend) is a portion of your business profits you pay yourself quarterly, monthly, or annually. Your business structure (see below) informs your tax obligations
- A salary is your fully taxed weekly, biweekly, or monthly paycheck. Unlike distribution funds, your salary is a line-item expense in your overhead
Step 2: Consider your business structure.
Whether your firm is still in the planning stages or fully launched, talk with your accountant or tax lawyer about the income-specific pros and cons of these options:
- For sole proprietorships, the IRS taxes all business revenue as the owner’s personal income. You can take a regular draw on profits, business conditions permitting, paying estimated quarterly tax payments
- LLC and S-Corporations may pay either a salary, a distribution, or both. The IRS considers an LLC’s profit as the owner’s income as well, whether or not the owner claims it personally. However, it treats S-Corporation profits that you leave in the business more favorably than personal income
- A C-Corporation can pay a salary and/or dividends (distributions) on profits, each taxed at a different rate
Step 3: Crunch the numbers.
As you calculate your compensation, be sure to:
- Consider your business stage. If you’re in startup mode and don’t have the luxury of venture capital or contracted income, it may take months or years to know your true profit potential. In this case, you may need to take distributions only when or if they will not adversely impact your company
- Adhere to best practices. Many experts, including those at the Small Business Administration, say that capping your compensation at 50% of the firm’s projected profits is a common best practice
- Avoid extremes. Owners of corporations must exercise good judgment when setting their salaries, since the government may view an exceedingly low or high income as a red flag.
For instance, if you’re paying yourself $10,000 a year to run your startup restaurant–more than $40,000 less than the market rate for this job–the IRS may think you’re trying to avoid Social Security and other typical salary taxes. Likewise, the government may see a very high salary in a C-corporation as a way to maximize the corporate tax deductions on salaries.
Step 4: Look toward the future.
Now that you’re a business owner, you have a new set of career goals–the first being that your business meets and exceeds the milestones you’ve set for success. This may require some patience and sacrifice, so that your company can become a greater means of support than you’ve ever imagined.
Talk with an M&T Business Banking relationship manager to discuss the many ways your business can support your professional and personal financial goals. Visit a branch or call us at 1-800-724-6070.
This article is for informational purposes only. It is not designed or intended to provide financial, tax, legal, investment, accounting, or other professional advice since such advice always requires consideration of individual circumstances. Please consult with the professionals of your choice to discuss your situation.