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Executives in larger firms often rely on their board of directors and the human resources department to establish pay scales, retirement plans, and health insurance policies. In a small company, these decisions fall to the owner.
While there’s not a one-size-fits-all formula for determining how much to pay yourself as a business owner, here are three factors to consider:
Determine your business needs. Conducting this exercise lets you know how much salary you can realistically draw without hurting profitability. For startups, owner compensation may be minimal. However, going too long without paying yourself a reasonable salary is not sustainable.
On the other hand, you want to prove that you’re in business to make a profit, otherwise the IRS may view your continuously unprofitable business as a hobby – and they may disallow any business losses.
Know the market. If you were working for someone else, what would they pay for your skills and knowledge? Discuss salary levels with small business groups and colleagues in your geographic area and industry to see if you’re in the ballpark.
Use the Department of Labor and Small Business Administration websites as additional resources to determine your salary. In the early stages of your business, you probably won’t draw a salary that’s proportional with the higher range of salaries, but at least you’ll learn what’s reasonable.
Determine affordability. Review and continually update your firm’s cash flow projections to determine the salary level you can reasonably sustain while keeping the business profitable. As the company grows, that level can be adjusted.
The IRS is focusing on businesses that do not appear to be paying a reasonable salary in an effort to avoid paying employment taxes. There is little to be gained by spending time fighting the IRS in this area.
Please call if you’d like to discuss what taking a reasonable salary as the owner looks like in your business.