When starting your own business, there will undoubtedly be surprises. One of those surprises could be related to your paycheck — or lack thereof.
After opening a business, most owners won’t pay themselves during the first year, said Kedma Ough, director of the Oregon Small Business Development Center Network. Many new owners are surprised when their profits are not high enough to support a salary that can fund their existing lifestyle.
“They are usually shocked when we are reviewing their personal financial statements, especially when they realize there is not a lot left for them to take as a salary,” Ough said.
Once you begin to turn a larger profit, you’ll be able to set aside some money for yourself. It’s crucial you pay yourself enough, not only to remain compliant in the eyes of the IRS, but also to reinforce your value as a business owner, Ough said. Even if it’s not as much as you expect, you should still earn a salary if your business is healthy enough to support it.
Average salary of a small-business owner
Yearly salaries for U.S. small-business owners and operators span from almost $27,000 to $155,000, according to data from PayScale, and the median annual salary is almost $60,000. Individual bonuses, profit-sharing and commissions contribute to most owner-operator salaries.
Several factors influence a small-business owner’s pay, including:
The development stage of the business. If you’re still in the startup phase, your salary may consist of what’s left after covering your operating costs and bills, which may not amount to much. But if your business is consistently profitable, you may be able to take home a percentage of that profit.
Experience as a business owner. Your years of experience impact your market value, affecting how much money you should earn. About two-thirds of small-business owners in the U.S. have 10 years of experience running their own operation.
Your business entity. If you operate a sole proprietorship, the IRS mandates you make an owner’s withdrawal depending on profits, rather than take a standard salary, Ough said. You must make the withdrawal from net profits, not revenue. You can make periodic withdrawals whenever you need, and the amount can fluctuate. You can take out more or less depending on your personal financial needs or the business’ performance.
If you operate a corporation, you’re required to pay yourself a traditional salary. You would receive regular paychecks of equal amounts and the IRS would automatically deduct self-employment taxes.
Why it’s important to set your own salary (and how to do it)
Setting a fair and accurate salary ensures you’re not undercutting your worth as a business owner, Ough said. As the person in charge, you may find yourself investing 50 hours one week and 60 hours the next, and your salary should reflect the elasticity of your time.
You may also need to pay yourself at a higher rate than you were earning as an employee to make up for the overhead costs that your employer previously covered, Ough said. For instance, if your employer paid you $50 per hour, you may need to pay yourself $100 per hour to cover costs such as income taxes, Medicare and Social Security.
When you become a business owner, you are responsible for paying for additional benefits outside of your salary, such as health care or retirement benefits, Ough said. One in 3 small-business owners receive medical benefits, while 1 in 6 have dental coverage.
You also need to pay yourself an accurate amount for tax purposes. The IRS expects business owners to take a “reasonable” salary based on industry standards, Ough said. If the IRS determines you are not meeting its reasonable compensation requirement, you may have to make adjustments to your income.
An inaccurate salary would reflect poorly on your cash flow statement as well. If your business earned a net profit of $60,000 but you decided to pay yourself $100,000, your cash flow would be negative and indicate a loss. Your salary needs to correlate with the amount you make in sales, Ough said.
There’s not one right way to determine your salary as a small-business owner, Ough said. The amount you pay yourself depends on your lifestyle expenses and your business profit.
“Usually the best way to determine your salary is to prepare a personal financial budget and decide how much you really need to pay yourself in your business versus how much you would love to pay yourself,” Ough said.
New businesses often do not deliver a high owner salary for the first five years, she said. You may need to limit your personal spending to your rent or mortgage, insurance, gas, groceries and other necessities.
“It’s best to review the amount you need to take each month that will not create an economic hardship for you to continue with your current lifestyle, minus all the extra disposable income you may have been spending on dinners, activities and vacations annually,” Ough said.
You may be able to calculate your salary as a percentage of your net profit. Here’s an example of how you could break down your finances based on a net profit of $100,000 and no additional employees:
- 20 percent, or $20,000 for a savings or a reserve account to keep money available for business emergencies
- 30 percent, or $30,000 for your estimated business taxes
- 20 percent, or $20,000 to reinvest in the business for future growth
- 30 percent, or $30,000 for your own salary
Need business funding? Learn more about small business loan options here.
The bottom line
It may be difficult to forgo a large entrepreneur salary for your first few years in business, especially when you’re working 60 to 70 hours a week, Ough said. But new business owners often become more understanding of the sacrifices employers make.
“They actually appreciate the difficulties employers face after they become an employer,” she said. “They not only have to review how much they make but they have to review how much they can afford to pay others in supporting their business.”
It’s best to check with an accountant to make sure your salary is optimal for your business, Ough said. An accountant could review your business expenses such as taxes, operating costs, loans, marketing, growth plans and personal expenses to make sure your business can adequately support all your costs. An accountant could also advise you on how to prioritize your profit. For instance, you may want to pay off debt as soon as you turn a profit, but doing so would reduce your salary.
It’s not uncommon for a new business owner to rely on their savings, a partner or their spouse to help cover personal expenses during the first few years, Ough said. Many new entrepreneurs also remain employed at a full-time job while building their own business on the side until it becomes profitable enough to support a regular income.
The amount and frequency of your compensation is entirely up to you, but it’s important to focus on your business needs. If you take too many resources for yourself, you may “starve” your business, Ough said.
“Usually the best time to start paying yourself is once all business expenses have been paid and the business has a percentage that is going back for reinvestment,” Ough said.