We’ve talked about how to pay your employees and independent contractors. But what about yourself? You’re working too, and since by this point you’ve already decided whether or not to separate your business and personal accounts, it’s time to figure out how your own salary fits in.
The first question to ask is, what kind of business are you? As a sole proprietor or DBA, your personal assets and business assets are essentially one in the same, so the money you use for personal items or costs can come straight from income you make from your business. It’s “a very easy and simple system,” says Laura D. Adams, host of the Money Girl podcast and author of Money Girl’s Smart Moves to Grow Rich, “because basically you can just take money as you need it.”
If you’re a corporation, partnership, S corp, or other incorporated entity, though, you’re going to need to do a little more thinking and planning. In our previous post about paying employees, we covered the various deductions that need to be taken out of paychecks come tax time: income tax, Social Security, and Medicare. Those same considerations need to be given to your own paycheck.
“All those payroll deductions and withholdings need to come out,” says Adams, “even on your own paycheck that you write to yourself.”
To determine what the actual amount of your paycheck should be, there’s not as much guidance as one might hope. The IRS dictates that you have to pay yourself a “reasonable salary,” but it doesn’t lay out what “reasonable” means.
Fortunately, a number of court cases over the years have set a semblance of legal precedent, and so there are questions you can ask yourself (some of which seem relatively obvious) to figure out what you should be taking home each pay period:
What is your experience and what are your qualifications? What is the description and scope of your role in the company, and how many hours do you put it? What’s the going fair market rate for your position? How well has your company done so far this year (and have there been any extenuating circumstances, like a recession or a natural disaster)? How much are you compensating other employees, and what is their experience as compared to yours?
It’s important to remember that as the owner of an incorporated business, you could, in some situations, pay yourself through dividends. But that opens you up for a lot of risk and legal action, which is why, says Adams, “you have to pay yourself like you would pay an employee.”
If you’re just starting out, you might not be able to answer all of the above. In that case, David Worrell, a managing member of Fuse Financial Partners and author of The Entrepreneur’s Guide to Financial Statements, offers what he calls his “quick rule of thumb”:
“Take nothing out of the business for the first two months,” he says. “In month three, pay yourself the profit you made in month one. In month four, pay yourself the profit you made in month two, and so on. In this way, you’ll be taking home what you actually earned while giving the company time to collect enough cash to pay you.”
Nevertheless, both Adams and Worrell suggest that as things get more complicated, it would be a good idea to visit a professional for advice.
“If you have an S corp, partnership, or LLC of any complexity, you should consult a CFO or tax expert for the most advantageous (and safest) ways to take money out of your corporation,” says Worrell. “But the above rule still applies; pay yourself only those profits that you have collected from prior months!”
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