Why Small Business Owners Should Pay Themselves a Salary

CoAdvantage – Should business owners pay themselves a salary? Apparently over a quarter (26%) of small business founders say no, according to CNBC.

This can be a legitimately tough question. Especially in the early days of a business, owners may not have enough cash flow to set up a recurring salary. Even if cash flow is regular, it may not be enough to support anything other than keeping the business going.

However, experts recommend that business owners pay themselves a salary as soon as it’s feasible. “People must be paid for their work,” Melanie Hopkins, founder of Finance Friend, a New York-based firm that helps entrepreneurs, told CNBC. “They don’t, because they have a scarcity mentality and fear that even if they’ve budgeted and everything looks good, they have to keep money in the business bank account. Not paying yourself leads to burnout, so carving out even a modest monthly payment is essential.”

Worse, not paying oneself a salary forces business owners to take money out of the business on an ad hoc basis. That can play havoc with the business’ own accounting, and it increases the risk that business owners will mix personal with business expenses. In the early days of a simple business, like a sole proprietorship, that may not be a big deal. As a business grows and its financial situation becomes more complicated, however, a business owner who has formed the habit of dipping into the business to cover personal bills and debts may start running afoul of tax regulations and other laws.

How owners pay themselves depends on the structure of the business:

– A sole proprietor or single-member LLC can draw money at will from their company. There’s no required tax reporting of these draws, so owners can just take money at will.

– Partnerships and multiple-owner LLCs must take “distributions” however. These can be of any amount, but they are reportable transactions via Schedule K-1.

The IRS, for its part, expects business owners of Schedule C or Schedule S corporations to pay themselves a “reasonable” salary. In fact, these business owners can get into tax trouble if they don’t pay themselves a regular salary. That’s because the IRS doesn’t want owners to pay themselves a small salary and take the rest of their income in dividends or some other financial vehicle taxed at a lower rate. There are many situations in which business owners might hesitate to pay themselves a full salary or a regular salary at all, not all of them legally problematic, but the IRS doesn’t want to give small business owners an opportunity to skimp on taxes.

The next question is: how much should you pay yourself?

Of the business owners that do pay themselves a regular salary, half pay themselves less than $100,000 annually. The average U.S. small business owner takes home $70,300, according to PayScale. The IRS requires salaries to fall in the same range as a comparable benchmark, e.g., what business owners in the same industry with companies of the same size pay themselves, or what the owner would pay someone else to perform the same work tasks. 

CoAdvantage, one of the nation’s largest Professional Employer Organizations (PEOs), helps small to mid-sized companies with HR administration, benefits, payroll, and compliance. To learn more about our ability to create a strategic HR function in your business that drives business growth potential, contact us today.