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How to Pay Yourself From Your Small Business

When you decided to become a small business
owner, making money may not have been your only goal, but it was probably one
of them.

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. 

How to Pay Yourself From Your Business
How to pay yourself from your business. (graphic source)

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.

Owner’s Draw

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:

Salary

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.

Dividends

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:

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.

Conclusion

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.