When you work for someone else, you earn a salary for the work you provide. Pretty simple.
Being your own boss is another matter entirely. You need to bring in money to run your personal affairs, but the business needs cash, too. Deciding how much income to take compared to what you should leave for the business is a quandary, indeed.
"It is imperative that the business owner know their income revenue cycle, payables and receivables. A critical issue to understand is cash flow, which is the lifeblood of any small business," says David Morganstern, a certified financial planner with CMC Advisers in Portland, Ore.
That includes paying yourself. Here are some tips to help you take the income you need while leaving your business with a decent operating budget.
There is No Formula
As a business owner, taking a salary is not as simple as being satisfied with what's left in the till after expenses are paid. Having a fixed salary, while inviting, may not be realistic because the financial health of each business is different--and fluctuates from year to year.
Your first consideration should be not about the business, but about your own personal living needs. Determine how much you need to pay the mortgage, food bills and other expenses, and that's the amount you strive to meet. But of course, business profits aren't likely to be as stable as your personal money needs, so you have to be flexible.
Lifestyle overhead should remain low to avoid any undue stress on the business, says Curtis Smith, a certified financial planner with Interactive Capital Management in Sugar Land, Texas. Low personal expenses will leave more money available for the business to maintain operating capital--and hopefully a cash cushion--for the future.
Next, look at your business budget, income and cash flow needs. Consider the following:
- How profitable is the business?
- What are the cash flow needs of the business?
- Does the business have an emergency funding source for protection during revenue downturns?
"The owner has to decide, based upon knowing their revenue and expense payments, how much they can reasonably take as salary," Morganstern says.
If business cash is tight and you don't take much of a salary, you can make up for your lower salary with a bonus--but only if the company can afford it.
If your business is in expansion or startup mode, you'll be tempted to forgo a salary completely so you can reinvest every available penny into the company. But that, too, has dangers. You may damage your personal credit, which may eventually have a negative impact on the business, and you may snare the attention of the IRS.
Ah, Yes, the IRS
Your business could become suspect to the IRS if it continues to lose money every year, and you pay nothing in taxes.
"If this appeared to be a hobby with no intention of being a for-profit business, the IRS could shut the business down, fine the owner or take legal action to cease business operations," Morganstern says.
This issue arises when someone does not take any salary for three out of five years. Then, the business appears to be a hobby and not a legitimate business.
"In those circumstances, the IRS is more prone to audit this return and inspect the business for legitimacy," Morganstern says.
The IRS knows business owners have a lot of discretion regarding what they are paid. If you choose to take a small or no salary to keep profits in the business for growth and expansion, and you can justify this properly, an IRS audit may have no findings. But if the business appears to be financing a lifestyle with deductions for losses and there was no intent on selling a product or service for a profit, expect the IRS to take stronger action.
CPA Smith shares the story of one business, owned by three people, where the owners tried to structure compensation to avoid FICA taxes. The three owners paid themselves $80,000 in salary but took nearly $600,000 each in compensation for the year.
"The dividend payout was $520,000, avoiding FICA taxes. The IRS took offense to this particular situation," Smith says.
Other Dangers of Skipping the Salary
Your business is "your baby," and as the creator of this enterprise, you've put a lot of love into the venture. If you allow your personal finances to suffer for the benefit of the business, the business may actually be hurt in the long run.
If you're not able to pay your personal bills and you accept a lower standard of living, you may start to resent the business itself. Your change in attitude will impact more than your motivation to work. It may also impact your customers. If they think the business is marginal, customers may leave and go elsewhere, fearing that your business may fail.
Skipping a salary can also have a negative impact on your ability to save for retirement. Small-business retirement plan contributions are based on salary or net income. Taking a small salary would mean small retirement contributions, and taking no salary could mean no retirement contributions.
"This can be detrimental to your retirement health as you get closer to retirement," Smith says.
Much depends on the type of retirement plan you use, though. Morganstern says as long as a business is a pass-through (partnership, LLC or sole proprietorship), defined contribution plans such as 401(k)s or SEP IRAs would allow contributions from the owner as long as the business had profits, even if the owner did not take as much in salary. That's because business profits are considered the owner's income, whether or not they take it as salary.