Q: I am fairly new to the world of self-employment. The thing I am having trouble with is figuring out how much I should be paying myself, when, and how much should be left in the business. I was wondering if you could shed some light on this. Thank you.
A: It's a good question, one many small business owners have trouble with. When figuring out how much to pay yourself, the most important thing to consider is your business' financial condition. Before you can decide how much money you can safely pull out of the business, you need to first figure out how much money your small business needs.
How much are your inventory, labor, marketing, and other expenses every month? If you can't, off the top of your head, say what your overhead is every month, now is the time to figure it out. It's time to make a budget.
I know, I know, the thought of making a budget sends chills down your spine. But I am also the bearer of good news. A business budget is no big deal, or need not be. It is nothing more than figuring out how much money your business usually makes, where you spend that money, where you should spend that money, and thus how to best allocate your resources. That's it.
Once you know how much comes in and goes out, you can begin to figure out how much you can realistically afford to pay yourself.
How much is that, you ask? Only you can say for sure after seeing your budget, but as you begin to formulate that number, keep the following three things in mind:
1. Your business structure often determines when, and how, to pay yourself. There are five forms your business can take: C corporation, S corporation, limited liability company (LLC), partnership, or sole proprietorship.
Only owners who have set their businesses up as C corporations are legally considered "employees" of the business. If your business is a C corporation, then you would pay yourself as you would every other employee — as part of normal payroll.
Many small businesses start their businesses as sole proprietorships or partnerships. Sole proprietors can pay themselves whatever they want; it depends almost entirely on how much profit you make, how much money your business needs, and thus what you can afford to pay yourself.
Partners must consider the desires of each other when determining how much they will be paid.
The same is true for LLCs that have more than one owner, with one caveat: You can make a distribution of profits legally, only if doing so does not impair the solvency of the business.
2. Avoid paying yourself as the money comes in. Many small business owners make this mistake. If they have a good month, they take the extra out of the business, if they have a bad month, they don't. Not only does this violate the Rule of the Budgets above, but it doesn't account for potential business emergencies.
It is imperative that your business checking account always has enough of money in it so that if something goes wrong, you can afford to fix it. If you pay yourself whatever comes in every month, saving for a rainy day will be impossible.
The smarter thing to do then is to come up with a figure to pay yourself that your business can live with, and pay that amount to yourself on a consistent basis.
3. Consider the tax consequences. F you have a C corporation, when you pay yourself, the business is responsible for payroll taxes on the amount you get paid.
In the case of a sole proprietor and partnership, whatever profits the business makes "flows through" onto your personal income tax — your business' profits or losses are considered your personal profits or losses. Partners and sole proprietors are also responsible for the self-employment tax, which runs about 15%.
The bottom line is this: Your business budget is the single most important factor when determining how much money to pull out. Once you know that, then you must consider your business structure, and then any possible tax consequences. Knowing these three things will enable you to make an informed decision regarding how, and how much, to pay yourself.
© 2010 Steven D. Strauss, “America’s small business expert.” www.MrAllBiz.com