Ways to Pay Yourself As a Business Owner - Accounting 101
As a company owner, you are certainly getting paid somehow. That being said, it does not necessarily mean that your approach is the most effective one. If you underpay yourself, you may not make enough money to make ends meet. However, if you overpay yourself, then you may be putting your company’s financial health at risk. This article will discuss some options for how small business owners can pay themselves so that you know which method will work best for you.
Two Methods to Pay Yourself As a Business Owner
There are two methods for paying yourself. These are the salary method and the draw method. The first is when you paid yourself a monthly salary just as you would do for regular employees. If you choose the draw method, you simply draw money from your business income as you deem appropriate. The draw method is more flexible as you can adjust the amount of money you get based on how the business is doing, but the salary method is more consistent. The method you choose should be based on the structure of your business and how involved you are in managing the company.
The Salary Method
As mentioned, the salary method allows business owners to pay themselves a fixed monthly salary. Outlined below are the advantages and drawbacks for this method:
Benefits of the Salary Method
If admin tasks are too much of a hassle for you, the salary method is the way to go. State and federal personal income taxes are automatically deducted from your salary, saving you all the trouble of going through paperwork. Moreover, when you are getting a fixed salary on a regular basis, it suggests that you have a stable source of income. This can be very helpful when you are applying for a mortgage or anything that involves credit. In addition, this method makes it much easier to keep up with your business capital, and it allows you to better manage your cash flow.
Drawbacks of the Salary Method
The biggest drawback to the salary method is having to figure out your own compensation while making sure that your company is operational, and is not double-taxed. Therefore, it is imperative that your compensation does not stray off the reasonable range, or else the IRS may become suspicious.
How to Properly Adjust Your Salary
Fortunately, having a set salary does not mean that you can’t ever change it. In fact, you can easily adjust it over time as your business grows. However, knowing the right amount to increase or decrease can be tricky. One simple rule to keep in mind is that the best time to increase your salary or give bonuses is after you have finally reached a break-even level in your business. This is because you want to correspond a salary increase with the company’s performance. Here are some of the best ways to approach this:
1. Annual Bonuses
Take note of the company’s performance from the previous year and give yourself a bonus that is compatible with the growth of your business after break-even. For example, if your business grows net profits by 15% in the past year, then you can give yourself a 15% lump-sum bonus at the end of the year.
2. Quarterly Bonuses
Distribute bonuses to yourself each quarter according to company growth after break-even.
3. Change Annual Salary Based on Yearly Growth
Instead of giving yourself bonuses, you may prefer to raise your salary each year based on the performance of your business. For example, if your company grew by 50% in the last year and your base salary is now $70,000, you may multiply this amount by 150%, which will give you a new salary of $105,000.
How to Determine “Reasonable” Compensation
It cannot be stressed enough how important it is for you to set your compensation in a “reasonable” range. To find the appropriate amount, it is recommended that you look for companies that are similar to yours, and your own salary should not be too far off from those companies’ founders or owners. That being said, there are other elements that you should also look at to determine a salary that is acceptable for both you and the IRS. These include your qualifications, years of experience, relevant training, business size, as well as the location and cost of living. The higher the marks on these criteria, the better the compensation package should be.
Regardless of which method you choose for yourself, there are certain guidelines that you must follow. Be sure to leave enough money for your business to run smoothly after each payment. Also, make sure that you are not using your company’s money as your personal funds. The best way to keep track of your finances is to record all your payments with payroll software.
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