How to Calculate Your Own Pay as a Small Business Owner

One of the most challenging aspects of running a business is figuring out how to pay yourself. It’s not always clear what the rules are, and many entrepreneurs struggle to strike a balance between reinvesting profits into their company and taking home a fair salary.

Entrepreneurs typically have a couple options available when it comes to paying themselves, which are dependent on the structure of a business. One option is to take a draw, which is a withdrawal of funds from the business’s profits. This is used by sole proprietorships and partnerships. The other option is to receive a paycheck, which must be used by incorporated businesses. Paychecks are compensation based on a predetermined salary and are subject to taxes and other deductions.

It’s important for entrepreneurs to understand the differences between these two methods and choose the one that is required for their specific business structure and meets their financial goals. If you have any questions about the best option for you, discuss the matter with your accountant. In this article, however, we’ll focus on some key considerations to keep in mind as you determine how much to compensate yourself for your hard work.

1. Reasonable Compensation

What would your pay be if you were doing the same work for a company that hired you? Are you making at least market equivalent or better? Many times, entrepreneurs remain focused on ONLY this aspect of their compensation, when doing so is actually a big mistake. There are tax implications of paying yourself too little (to avoid payroll taxes if you take a paycheck, for example) or too much. 

2. Retirement plan

When you work for yourself, no one is going to fund your retirement for you. Although the Social Security program helps, it’s up to you to set aside additional money for a livable future when you can’t or don’t want to work anymore. Talk to your accountant and retirement advisor about how much you should be setting aside for your retirement and how you can factor that into your own pay. 

3. Benefits

Employees get paid time off, health insurance, and bonuses–and you should too! These benefits should be part of your compensation package as an entrepreneur, and there are many tax advantages as well

4. Taxes

You need to cover taxes that will be incurred on your pay and your business profits, including:

• Normal withholding for federal income taxes, state and local income taxes, Medicare, and social security. If you receive a paycheck, these will be deducted; however, those deductions may not be sufficient to cover your entire tax obligation since they don’t account for taxes on your profits. If you take a draw, you may not have withholding, but you will need to factor in self-employment taxes at 15.3%
• Taxes on your profits. For sole proprietors, partnerships, LLCs, and S Corps, your taxes will be figured on your business’s profits when you complete your federal income taxes. They will “pass-through” from your business to your personal return. Don’t let this part surprise you!
• State business taxes. If your business does business in multiple states, you must file a tax return for each state. Many states collect taxes based on flat corporate fees, the revenue you earned in that state, state payrolls, and/or the value of property owned in that state.

Check with your tax advisor so that there are no surprises in your tax bill for your business or your personal returns.   

5. Profit

As an entrepreneur, you take on additional risk in owning your own company and should be compensated accordingly. Your capital is tied up in your business and should be earning a good return in addition to your regular salary or draw.

Complete Compensation

It’s normal to take a smaller paycheck in the first few years as your business grows, and you might even feel like you can’t afford to pay yourself an amount that reflects all the above components. In that case, it might be a good idea to evaluate your pricing, your volume of work, or your business model.

Remember to review your salary regularly and adjust as necessary to ensure that you’re meeting your financial goals and building a sustainable business. Determining the right amount to pay yourself as a business owner can be a complex process, but it is a key component of achieving long-term personal and professional success. By following the steps outlined in this article and seeking guidance from trusted financial experts, you can ensure you’re compensating yourself fairly and sustainably.