As a business owner, it may be second nature to remember to pay your employees or adequately invest in your business. However, it’s just as important to pay yourself.
There are a few ways a business owner can pay themselves while accounting for business debts and taxes. Here’s how to calculate your salary and determine when and how to pay yourself.
Ways to pay yourself
Here are two common ways small business owners can pay themselves in their business:
- Salary: With the salary option, you can pay yourself just as you would your employees — including withholding taxes. When calculating your salary, use similar jobs in your field as a reference. Keep in mind, the IRS will compare your salary to others in similar fields to ensure it is “reasonable.” This arrangement is typical for owners of corporations (S corps and C corps), who are taxed on both their personal income from the company and on the reported profits of their business.
- Owner’s draw: An owner’s draw means you transfer money to yourself from your business’s profit as needed. Although you won’t need to pay taxes for each draw up front, you will have to pay self-employment taxes either quarterly or annually when you file your tax return. This payment arrangement is typical for owners of pass-through entities like sole proprietors, partnerships, and most limited liability companies (LLCs).
Tips for setting your compensation
Calculate your net income
Calculating your net income ensures your business can cover expenses before calculating your own pay. This step is crucial to avoid debt or even bankruptcy. First, subtract the cost of your business’s expenses (such as employees’ salaries, rent for your office space, etc.) from your gross revenue to find your net income. Once you subtract the amount of taxes to set aside, you will pull your pay from this figure.
Consider tax savings
Planning (and saving) throughout the year is necessary to keep tax payments from adding up. According to the IRS, most corporations and self-employed business owners that will incur over $1,000 in tax payments per year are required to submit and pay estimated quarterly taxes. Whether you are a new or existing business owner, confer with an accountant to find the tax specifications required for your business and to avoid incurring penalties.
Tax calculations should always occur before taking expenses out. A good rule of thumb is to save 30% of your income for taxes. This percentage may be higher if you or your joint filing partner are in a higher tax bracket.
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Planning (and saving) throughout the year is necessary to keep tax payments from adding up.
Factor in your business debt
After accounting for tax payments, you can use these funds to pay off your business’s debt. If you’ve taken out any loans or used a credit card, your lender most likely requires a minimum payment each month. Subtract that total minimum debt payment from your net monthly income. If you have extra funding left over after paying yourself, you can increase your monthly payments and clear your debt more quickly.
Create a business savings plan
Build up a savings buffer while you have the money for any new hires, training programs, or emergency funds. Figure out which goals are most important to you and which you can put on hold. Your future self will appreciate the effort you take to set aside funds for your business goals and divide them into monthly savings.
How much should you pay yourself?
Once you’ve subtracted all the above allocations, you can begin to calculate your own pay. The number that remains is considered your annual salary. You can divide that by 12 for your monthly salary or by 52 for your weekly salary. Further, divide your weekly salary by the number of hours you work to find your hourly pay.
U.S. small business owners make around $70,000 on average, but many do not take a salary in the first couple of years. On the other hand, some business owners may pay themselves too much and limit the growth of their business. You should pay yourself enough to live on, but be realistic about what you need to live and what might be excessive.
[Read more: How to Do A Competitive Salary Analysis]
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