You might start out as a freelancer / 1099, but then decide you can start your own business. If you go down this path, you will have to figure out how much you should pay yourself. Here are some tips.
Here are some basic rules for how you should think about paying yourself
- There are no rules to how much you pay yourself.. but below are some things to consider
- If you want to pay yourself, you need to incorporate (according to the IRS)
- Payment should be reasonable (see below)
- If you can afford it, pay yourself, but pay yourself last — after paying off expenses, employees, etc.
- Work with your accountant to identify potential deductions (at the beginning of your business) so you can set up your accounting software properly and more important, pay less in taxes later on.
- Pay yourself what you are worth (not more), so do some research (More on this below)
One (Wilder) rule of thumb:
- Aim for 50% Gross Margin
- Aim for 30% Operating Expenses
- Aim for 20% Net Income Before Taxes
… That is of course, if you can dictate what you salary is. If you can’t, however, think about using the formula for the money you do earn
- Paycheck / Paying yourself- Even if you don’t need the money, it is good to get in the habit paying yourself to set up payment processes
- Withdraw money basis on the how the company is structured and also has tax benefits as you are reducing your overall process
- Put some money away for future, personal use
- Recommendation: Write up an agreement to pay yourself later (might want to put something in writing in case you grow and take on new investors, business partners, etc.).. deferring payment to yourself, though, becomes a liability for the company and needs to be accounted for.
How to start and How Much
- If you pay yourself, set up a consistent time / day to be paid such as weekly. Start by paying yourself as little as possible, but enough so you don’t struggle in making ends meet. The key is not to stress about having enough money to eat, pay bills, etc. Otherwise, there could be added stress to your life as you try and make ends meat. This can also be the case if you have a spouse or partners, etc.
- Defined as the amount a similar business would pay for similar services
- Most officers of a company are generally employees with wages and subject to the same tax issues.
- Wages should be ‘commensurate with your duties in the company’
- Must prove services were completed/performed
- You need to prove that pay is reasonable which depends on the services you provide
- IRS suggests you consider the followings (This is taken from the IRS site)
- The duties performed by the employee
- The volume of business handled
- The character and amount of responsibility
- The complexities of your business
- The amount of time require
- The cost of living in the locality
- The ability and achievements of the individual employee performing the service.
- The pay compared with the gross and net income of the business, as well as with distributions to shareholders if the business is a corporation
You might also want to talk to some Founders who have started companies comparable to yours and see what they pay themselves. Ask them the number of employees the have, their revenue, and years in business. This also is a good way to jump start networking with your industry peers.
Based on Legal structure
Your legal structure can impact what you can pay yourself. Basic rule, however, is this: If you want to pay yourself, incorporate! If you are an officer of a corporation
- Must be on payroll
- Must receive paychecks / direct deposits
- Must include / withhold taxes for Social Security, Federal, State (medicare)
If you are part of an S-Corp:
- Must receive a paycheck
- Company doesn’t file own taxes (same with LLC)
- Can take money beyond your regular salary
- An S-Corporation is not subject to corporate tax rates.
- Need to pay reasonable salaries to self and employees
- Can pass loses to shareholders which will reduce their taxes
- Note: Need to set up a board of directors which could dilute your influence in the future direction of the company.
If you are part of LLC
- Pay yourself by taking money out (Note: If you just pass the money to the person who owns the company, then you are paying yourself as an employee)
- Paying yourself is referred to as a ‘draws’ and is different from paying an employee. If you pay an employee employee, federal and state taxes are withheld. You also withhold social security and medicare.
- If you take a draw there is nothing withheld and therefore you have to make your own estimated tax payments, usually quarterly), pay your own taxes. Note: If you pay yourself and don’t do quarterly tax estimates (paying the IRS), you could be in for a surprise — sticker shock — when you see your tax bill at the end of the year. (I know : )
- Use a check from your LLC bank account (keep personal and business banking separate)
- Don’t need to set up a board of directors
If you are part of a Sole Proprietors/Partners
- Free to pay themselves whatever they want
- Payroll taxes/withholding don’t apply, but each person pays the same
- Recommend paying on regular basis
- Do quarterly taxes estimates with IRS (so should build a business plan with your tax estimatesPartners are not employees and should not be issued a Form W-2 in lieu of Form 1065, Schedule K-1, for distributions or guaranteed payments from the partnership.
Always think about deductions which can be viewed as type of compensation and can reduce the amount you pay in taxes.
- Form of payment to an owner
- Defined as both “ordination and necessary”
- Ordinary — common and acceptable in your trade or business
- Necessary — is helpful and appropriate
- Can not include personal, living or family expense
- f an expense is for both, divide them and deducted the business part
- A word about your Home and your Car:
- You can deducted mortgage interest, insurance, utilities, repairs and deduction
- You can deduct the percentage of the house (% of rent or mortgage used for your work)
- You can deduct car expenses if you use your car only for business
- If you use your car for both for personal and business, you must divide your expenses based on actual milage. Formulas to calculate car deductions:
- 56 cents per mile for business miles driven
- 23.5 cents per mile driven for medical or moving purposes
- 14 cents per mile driven in service of charitable organizations
- Tip: Keep expenses separate from busines
The Right Payment
- Determine what’s appropriate after taking out business costs, taxes, money invested back into the company
- Talk to other comparable companies
- Talk to your local SCORE, SBDC, etc. offices to determine what other companies that are comparable in size (revenue, #employees, etc.), stage of business, etc. are doing
- Determine if you afford to pay yourself
- Determine if your company is profitable and if it is reward yourself
- Think About what you pay your employees
- Note: If you overpay yourself, it will raise a red flag for the IRS so work with your accountant to determine ‘what’s reasonable’
When not to pay yourself
- If you have large account receivables
- If your employees have not been paid
FINAL REMINDER Have the end in mind — but do this by creating a business plan