As a small business owner or independent contractor, you face an interesting question: What should you pay yourself? In this post, we’ll go over some of the factors you should consider when deciding on what your business owner salary should be.
What should you pay yourself? 4 major considerations
It can be tough deciding what you should pay yourself as a small business owner. Here are some things you should mull over before calculating what your salary should be.
What can you afford?
Make sure you have enough money for food, shelter and transportation for you and your family. If you’re constantly worrying about these important aspects of life, it’s going to be tough to run a successful business.
Of course, your food, shelter and transportation needs are variable. There’s a balance between eating at Michelin Star restaurants every week and only eating rice and beans for every meal. Likewise, there’s a comfortable middle place between driving a luxury vehicle and driving in a beater you don’t feel safe in. Find the middle ground that will keep you and your family happy.
The first step is to put together a comprehensive list of your living expenses and then list your expected income (from you and your spouse, if you have one), assets and savings. If you have this already … Great job! But, only a third of Americans say they keep a detailed budget. This is a critical first step in deciding your pay and keeping a detailed budget is also great practice for how you should run the finances of your small business.
What can your business afford?
Creating a balance sheet for your business will also help you decide what you can pay yourself. It’s key to try and pay yourself with the profits of the business, not just the revenue.
That’s the ideal scenario, though. Many small businesses don’t make a profit in the first couple of years. If you can survive without a salary until the break-even point, that’s something to consider. But, as mentioned above, make sure you can afford the important things in your life—even if that means taking a net operating loss for the year.
Salary now vs. investing in business
As a small business owner, you’re a risk-taker.
Striking out on your own has more dangers than working as an employee for someone else’s company. But, it also has more upside. That can play into the decision on how much you pay yourself: Do you take a larger salary now or reinvest those profits into trying to grow the business and reap the rewards down the road?
Do the research about market size, how quickly you could realistically grow in what time frame, what the profit margins are and then balance that with your personal finance needs.
What does the government say?
The government expects you to take reasonable compensation from your business. What, exactly, is “reasonable?” The IRS defines it as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.”
If that still sounds unclear … you’re right. What’s reasonable in some markets could seem unreasonable in other places. Lean on your network and see what other small business owners are paying themselves.
Some good questions to ask about the reasonableness of your salary are:
- How much would you be paid for your services if someone else owned the business?
- Is your salary equal to the duties being performed?
- Is your salary reasonable for someone with your experience level and responsibility?
- How does your salary compare to that of the employees? Does that seem fair?
Your payment can also depend on how your business is structured. If you’re a sole proprietor, you generally have more freedom on what you pay yourself. But if you’re part of a partnership, LLC or incorporated with shareholders, you may have more restrictions.
What’s the average small business owner salary?
The median salary of a small business owner in the United States is $59,244 a year, according to data from PayScale. Your salary will vary greatly based on your years in business, experience, industry, personal needs and geographic market.
Another PayScale report revealed how big of an impact experience can have on small business owner salaries. It found a small business owner with less than a year of experience had annual salaries ranging from about $35,000 to $75,076. Owners with more than 10 years of experience earned more than $105,757 per year.
Once you’ve decided on your salary, build it into your business plan. Some independent contractors or business owners don’t pay themselves on a regular basis. Instead, they may wait until after a deal closes or do it periodically. Regularly paying yourself and building it into your business plan can help you have a more stable financial picture moving forward—for both your personal life and for the balance sheet of your business.
How to make your salary go further: Maximize deductions
Whatever you decide to pay yourself, you’re going to have to pay income taxes on it. One way to make your salary go further is by maximizing your deductions in order to lower your taxable income.
Here are three major deductions small business owners should be looking at:
The IRS allows you to deduct the costs of nearly any expense for business. This applies as long as these costs are considered ordinary and necessary, directly related to your business and for a reasonable amount.
Your business expenses can include the costs of running your business, company software, advertising, tax prep fees and more. The IRS will scrutinize this deduction because some businesses try to abuse it. That’s why it’s important to keep diligent track of all your business expenses so you have proof.
Net operating loss
If your business doesn’t make any profits, you may be able to use a net operating loss for some tax relief.
A net operating loss is common for small business owners, especially during the first couple of years. If you’re a sole proprietor, LLC, S corp or partnership, you may be able to pass the business loss to your individual return.
What’s interesting about this is that you may apply a net operating loss to past tax years—this is known as carrying a loss back. If you expect your business (and your income) to sharply increase over the next few years, you could also use your net operating loss to reduce future tax liability. This is known as carrying a loss forward.
While losing money is never pleasant, this can help ease the pain. As always, consult your tax professional to see what the best approach for your taxes should be.
Every mile you drive for business purposes is worth 58 cents in 2019, thanks to the mileage deduction. That may not sound like a lot at first. But, think about how often you drive for work. Every trip to pick up supplies, meet clients or to the post office and bank can lead to more money back in your pocket.
The only way to make sure you get the most out of your miles is by tracking every single drive. If you ever get audited, the IRS will want a mileage log of all your business, personal and commuting miles.