Starting out, an owner’s salary tends to be whatever is left over after paying business expenses. As you take on employees, distribute equity, and form a more complex business structure, your salary needs to be more carefully thought out. Reevaluate your salary on a regular basis — once a year at a minimum — to account for changes in your personal needs, your business’s needs, and company profitability.
1. What You Need
When you start your business, you simply may not have the ability to pay yourself what you deserve. It’s tempting to forgo a salary completely but you need to be realistic about what you need to live on. Entrepreuner.com provides a free worksheet you can use to calculate your annual expenses. Make sure that your business salary, plus income from other sources and any savings you’ve allocated, will reasonably cover your personal expenses.
2. What Your Business Can Spare
As your business grows, your salary may be able to grow with it. However, you’ll probably have increased obligations to other stakeholders. Make sure that your salary leaves enough left over to satisfy the needs of loan creditors, employees, and other co-owners. Ideally, you’ll also keep some funds set aside in a cash reserve to reinvest in your business and cover emergency situations.
3. Your Company’s Profitability
It takes a while for many businesses to become consistently profitable. You may experience high income in some years and low income in others. Rather than overstretch your salary, create a bonus structure to reward yourself during the good years. You can also pay yourself extra money in the form of a dividend or an owner’s draw, depending on your business structure.
4. What You’re Worth
Once your business is consistently profitable, the baseline for your salary should be the market value of your services. The BLS offers industry data, and you can scope out the salary listed on recent job postings. To account for regional pay differences, look for information specific to your area or translate figures using a cost of living calculator.
5. Your Workload
Recognize your hard work and sacrifice when you set your salary. As an owner-employee, you’re more likely to burn the midnight oil compared to an average employee. Set your salary proportionately based on how many hours you work relative to your other employees. For example, if you pay yourself $90,000 a year but you’re working 3,000 hours annually, you’re getting paid the same per hour as the employee that works 2,000 hours a year and is paid $60,000.
6. Any Tax Consequences
If you’re profitable but not paying yourself a high enough salary, you may incur the wrath of the IRS. Specifically, if you have an S corporation, you actually pay more taxes on your salary than you pay on your share of company earnings. This gives S corporation employee-shareholders an incentive to minimize taxes by setting an artificially low salary and taking higher draws. If your S corporation salary is unjustifiably low, the IRS may investigate and issue penalties.