When you decided to become a small business
owner, making money may not have been your only goal, but it was probably one
But often, especially in the early days of business ownership, the money can end up flowing the other way. More than two-thirds of small business owners invest “a substantial portion of their personal savings” into their companies, according to an American Express survey.
Even when small business owners do pay themselves, it can be on an occasional basis, without a clear understanding of how much they can and should be getting paid.
So in this tutorial, you’ll get some tips on how to pay yourself the right amount.
We’ll look at the different ways of paying yourself, how to decide on how much is enough based on a range of criteria, and how to ensure you’re striking the right balance between funding your business and meeting your own personal needs.
We’ll also take a brief look at some of the legal and tax implications, but keep in mind that the rules vary widely in different countries and in different situations, so for specific issues it’s always worth getting professional advice from a lawyer or accountant who’s familiar with your individual circumstances.
1. Understand the Different Ways of Paying Yourself
As a business owner, you can pay yourself in several different ways. Let’s start by defining the main approaches you could take. Of course, they’re not mutually exclusive: you may end up using a combination of these methods at different times.
Which method you choose will depend on a number of things, like how often you want to be paid, what type of company you run, and which solution is more tax-efficient for you. We’ll look at some of those considerations later, but for now, let’s get clear on the definitions.
When you take a “draw” from the business, it’s a simple, one-off distribution from the company’s accounts to your own.
Don’t think of it as simply writing yourself a blank check, however. It has to be accounted for, just like any other payment. It will be taken out of the “owner’s equity” account on the balance sheet. If you need a refresher on what that is, you can refer back to my tutorial on reading a balance sheet:
You’re probably familiar with this one. It’s the way that most regular employees get paid, receiving a paycheck for the same amount every month or other agreed-upon period. As a business owner, you can also pay yourself a salary for the work that you do.
A dividend is a distribution of some of the profits from the company to its shareholders. Dividends are typically paid on a regular schedule, such as once or twice a year, and tend to be linked to the level of profit. For example, a company may pay 5% of its profits out to shareholders each year, retaining the rest for investing in future growth.
If you own the company outright, you’ll be the only shareholder, so dividends will go only to you. If you have partners or investors who own equity stakes, they’ll also be entitled to dividends when they’re paid. Also note that dividends can only be paid from retained profits, so you’ll have to make sure that the company has accumulated enough profit to pay out the dividend (it’s OK to pay out retained profits from prior years, even if you made a loss this year).
2. Pay Yourself From Profit, Not Revenue
Let’s start with the basics. Just because money is coming into your business, it doesn’t mean it’s available for you to take out. You’ll also have expenses to pay, and those can often come much later. You may get paid by a client today, for example, but have to pay rent on your office space at the end of the month, and then have a tax bill to pay several months later.
So it makes sense to pay yourself from profit, not revenue. As we saw in the last section, dividends can only be paid from profit. But whichever method you choose, you should use profit as your pool from which to draw payments, not revenue. Make sure all your expenses are accounted for before taking money out for yourself.
For more details on the difference between revenue and profit, see my tutorial on reading an income statement:
3. Forecast Your Cash Flow
Profit is not the only consideration, however. You also need to make sure you have sufficient cash flow to pay yourself. If you take a draw from the company funds and later find yourself short of cash with which to pay business bills, you might have to put money back into the company, which could be very messy and also create unnecessary tax liabilities.
So it’s best to make sure you’ve accounted for everything and have a small surplus set aside within your company to accommodate any unexpected expenses that come up in future.
To learn more about forecasting your cash flow and the difference between cash flow and profit, see the following tutorials:
- FinanceHow to Manage Cash Flow More EfficientlyAndrew Blackman
- FinanceHow to Read a Cash Flow StatementAndrew Blackman
4. Consider Your Legal Structure and Tax Situation
When you set up your business, or at least in the early stages, you chose a legal structure. You may have set up as a corporation, a partnership, a limited liability company (LLC), or perhaps you just kept things simple and remained a sole proprietor.
That legal structure can make a difference to how you pay yourself. For example, it’s often beneficial for the owners of corporations to pay themselves larger salaries, because it reduces the company’s profit and therefore its tax bill (although be aware that the tax authorities keep a close eye on this and will want to make sure your pay is reasonable—see section 7).
Because the different legal structures and their tax treatment vary so much by jurisdiction, I won’t go into too many details here. This is an area where it’s best to consult your lawyer or accountant for specific advice. Just keep in mind that the legal entity you’ve chosen will have implications for how you pay yourself, so you need to understand what those implications are.
5. Keep Your Payments to Yourself Regular
If you decide to pay yourself a salary, of course that will be a regular payment. But even if you decide to stick with taking an owner’s draw, it’s good practice to have a regular schedule for doing this. Even if the amount varies depending on how much profit you’ve made, having a regular schedule is good for planning purposes.
It’s also good for your own personal situation. Budgeting can be tough when your income is up and down; as I mentioned in my tutorial on effective budgeting, it’s much easier when you create a regular income.
It’s particularly important to have a regular schedule when you have other employees working for you and they have access to the accounts. It can be bad for morale if your staff see you taking money out of the company when you feel like it. It’s better for them to know what your schedule is, so that they know the payments are legitimate.
For the same reasons, you should also follow a specific methodology for setting the amount of the payments. We’ll look at some of the possibilities for doing that in the next section and answer the question.
6. Decide on a Payment Method and Amount
How much should you pay yourself from your small business? There are several different approaches you could take to setting the amount you pay yourself.
One common approach is to look at the competitive landscape. Do some research on what people are getting paid in your industry, either to run companies or to do the kind of work that you do.
In the U.S., you can find some useful salary benchmarks on the Small Business Administration’s Income Statistics page. You can also search on a website like Payscale.com. Don’t forget to take regional differences into account—in most countries, there’s a big difference between salaries in the capital city and a small town.
Another option is to pay yourself a percentage of profits. Doing so doesn’t mean that your income has to fluctuate with your profits month by month. It could still be a fixed amount, but based on what you expect your profit to be for the whole year.
If you expect your business to make $100,000 profit this year, for example, you could decide to take half of it as a salary, so that’s $50,000. Your salary each month would be $50,000 / 12, or $4,167.
When setting the amount, it’s important to get the right balance between meeting your own immediate needs and investing for growth. You don’t want to put financial stress on yourself, but you also want to leave enough money in the business to fund its growth (as well as covering expenses, as mentioned earlier).
If you’re in the early stages and profits are still weak or non-existent, try to minimize the amount you take out. Hopefully you created a break-even plan for your business and set aside savings or created alternative sources of personal income to cover the expected period before the company begins to generate sufficient profits.
7. Make Sure It’s “Reasonable”
As I mentioned earlier, certain legal structures can have their own tax implications, and of course you want to pay yourself in the most tax-efficient way.
But in the U.S. and other countries, the tax authorities will also look at what you’re paying yourself to make sure you’re not gaming the system. If your pay seems way out of line with what other people in your industry are getting paid for similar work, then you may find an investigation or penalty coming your way.
“Reasonable” is, of course, quite a difficult term to pin down, but it means that you need to do at least some research into what other companies are paying (see the previous section) and to have some justification for your salary and how it relates to the actual work you do.
8. Always Pay Your Employees First
In this tutorial, we’ve talked a lot about paying yourself, but what about some of the situations in which you shouldn’t pay yourself?
If your company is in financial difficulty and you’re struggling to pay the bills, then you may want to put your own pay on hold for a while. Certainly your employees need to be paid before you. If their paychecks have been delayed and they see you happily collecting yours, you can expect to see them sending their resumes out to other firms before the day is out.
Similarly, if you’re falling behind with loan repayments or unable to pay supplier invoices, it’s probably a bad time to be taking out money for your personal use.
Hopefully these are just temporary shortfalls, so you’ll be able to get your paychecks back on track when the crisis has passed. If you’re struggling more seriously with debt, see my recent tutorial for tips on digging yourself out of it:
These are a few of the situations in which you shouldn’t pay yourself. In general, we’re talking about quite serious financial crises. In the day-to-day ups and downs of business, however, don’t worry about making your own pay seesaw too. As long as the situation is not too bad, try to keep it level in good times and bad.
In this tutorial, you’ve seen a range of different approaches for paying yourself. You know the difference between a draw and a dividend, between paying yourself from revenue and profit, the different methods you can use to set your pay, and much more.
You’re now in a position to be more methodical and consistent in how you pay yourself. Whichever approach you choose and whichever amount you decide on, you can be assured that you have made the right decision both for yourself and for the health of your business.