How Much Should My Business Pay Me?
You own the business, now how much should you get paid for your hard work and expertise?
In Part 1 of this two-part series, we looked at variables of the most-common business structures and how those play into paying business-owning individuals, and how the business structure determines how a business is taxed (which can play a role in determining how and what is paid out to owners).
Here in Part 2 we delve deeper into those five business structures and some best practices on owner compensation – while appropriately budgeting and leaving working capital for the business to operate.
- Sole proprietor – Owners of sole proprietorships pay themselves through distributions; however, they will be taxed on the business’s net income (sales or revenues minus cost of goods sold minus expenses) regardless of the amount of any distributions. Distributions and net income do not have to equal each other. A good rule of thumb is for the owner to leave at least a few months’ worth of expenses in the business bank account for emergencies. Budgeting and cash flow – for the business and for the owner’s personal life – together is the key to success here. For example, if a sole proprietor’s business has net income of $75,000 per year but the owner can find a way to only distribute $45,000 for personal expenses / personal income, that leaves $30,000 in the business bank account as an emergency fund or as savings toward growing the business – and that is the start of a healthily run business. Conversely, if the owner distributes all the business’s $75,000 net income for personal payment, then that may drain the business of all working capital; that could force the owner to then fund or contribute money back into the business to operate the following year.
- Partnership – A partnership pays the owners of the business through guaranteed payments. Guaranteed payments are a way for the partnership to compensate owners for their services, and to control which owner will be compensated based on the sweat equity put in by the owner. An example of this is if a partnership has three owners who all have equal ownership in the partnership, but one of the owners only works 10 hours per week while the other two each put in a full 40 hours a week of hard labor. Instead of splitting the income three ways equally, the partnership can put an hourly rate value on each owner’s work time and pay them accordingly. The principles of budgeting and cash flow planning also are very important in a partnership. Keeping a business emergency fund of a few months of expenses and eliminating or avoiding debt can keep the business viable and increase distributions paid to the partners down the road.
- Corporation – If the owner of a also works for the business, then the owner will receive a payroll check with all the necessary payroll tax deductions. In these cases, usually the owner or shareholder is also a corporate officer – like the president or CEO – and collects a salary. Oftentimes the corporation can also pay for fringe benefits, things like cost of leave, employee insurance, transportation, etc. These are additional expenses for the corporation that are not taxable to the owner-employee, but a deduction for the corporation. The pay ranges can vary widely with a C-Corp. It can range from no wages if the corporation is not profitable to paying out all the profits in wages to corporate officers to reduce the tax liability to the corporation. It is best practice to stick to industry averages when paying wages for actual work performed. A good place to start on how to determine what wages should be is this data table of wage rates by industry from the state of Montana. This table can be sorted by year, industry, occupation, occupation level and wage type, and it shows the wages at certain percentiles for low to high wages at all occupations.
- S corporation – An S-Corp is required to pay its owners a reasonable wage or salary for services performed. The owner or owners receive wages through payroll just like a and the typical employee. S-Corp owners who are not paid a reasonable wage run the risk of the IRS reclassifying all distributions they received from the S-Corp as wages – therefore owing payroll taxes on those distributions. This is an area that has been litigated many times at the United States Tax Court, and the IRS normally wins these cases. So, it is always best to use an industry standard or above-industry standard when determining owner compensation. Many owners think they can get away with paying the bare minimum wages of their state department of labor minimum ($38,100 in Montana), however, this amount does not reflect any sort of industry standard, nor should it be used as a blanket wage for owners across many different industries. It’s best to err on the side of caution and have good hard data when determining a salary or wage to the owners. Again, the Montana table of wage rates by industry is a good place to start. But it’s important to note that other factors can come into play – like cashflow, the number of employees, and equipment or other assets. If an owner has no employees and minimal equipment, and 100% of the revenue is derived from the owner performing services, then most, if not all the net income should be paid out as wages. Conversely, if the business has many employees and a lot of fixed assets, and the owner works 10 hours per week, then a smaller wage would be sufficient. All these types of circumstances should be documented and on at least an annual basis.
- Limited Liability Company – As we discussed in Part 1, an LLC can elect to be taxed as any of the four entities above depending on the owners’ wants and needs. If it elects to be a C-Corp or an S-Corp it will pay wages to the owners. If it does not make this election, it will pay out its profits as distributions to the owner (sole proprietorship) or owners (partnership). An LLC is truly a hybrid and allows choices at the inception of the business.
As you can see, this is not an easy question to answer. It really does depend on a multitude of factors that begin with your type of business and legal structure. And then your needs and future goals. It’s wise to review the requirements and options for your business situation with a professional CPA and then to review those decisions on an annual or periodic basis. If you would like to go over the pay structure in your business, please call and set up an appointment with one of our Montana CPAs.
** This article is not a complete listing of all the details related to this business / accounting topic and you should contact your CPA for a more detailed discussion regarding these items and how they may apply to your specific situation.
Photo credit: Pepi Stojanovski, unsplash.com