You have spent long hours getting your business started, and you continue to work long hours to ensure it runs smoothly. You deserve to be well paid for the work you do, so pay yourself what you are worth. There is another reason, though, for doing so. It is good business.
As a small-business owner, you should treat your business like a business. Not a side job. Pay yourself, but not by dipping into the business account whenever you want. Put yourself on the payroll.
You can pay yourself one of two ways: salary or draw. Which is best? It depends on your business structure (sole proprietorship, partnership, LLC, corporation, S-corporation), so I recommend consulting a professional tax adviser. It is important you get qualified advice because IRS fines for payroll-tax errors can be hefty.
The main difference between earning a salary and getting a draw is, with a salary, regardless of business structure, you will receive a regularly scheduled paycheck, which will have deductions for Social Security, Medicare, federal income taxes and state income taxes (if your state requires them). Your business will also incur payroll taxes. With a draw, if your business is a sole proprietorship, partnership or LLC, you will incur no tax deductions at the time of the draw.
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There are three reasons you should pay yourself a salary.
First, Social Security is based on the amount of income you have earned the last three years. If you are dipping into the business account from time to time because you are not getting a paycheck, in the eyes of the IRS you have no income. So your Social Security contributions will be zero, and your Social Security benefits will be practically zero.
Second, your business credit and your personal credit should be kept separate. You cannot develop your personal credit if you are using your business account to buy personal items.
Third, when you are on the payroll, your books accurately represent your business expenses. If a prospective buyer analyzes your finances and your salary is on the books, he can accurately calculate your business’ valuation. However, if you have not been receiving regular paychecks, and thus earning less than you are worth, your actual business expenses will be higher than the books indicate because the new owner will have to pay your replacement more than you were earning. Your business’ valuation will be lower than your books indicate, meaning your business is overvalued, making your business less financially attractive.
You may have no plans of selling your business any time soon, but I suggest you begin preparing now, so things are in order when you begin thinking about it. Prospective buyers will need to know how much it will cost to replace you because they will need to factor that in when analyzing your books. If you have been on the payroll, you make it easy for them to get an accurate valuation of your business.
You determine how much you pay yourself, but the IRS requires that your compensation be reasonable for the work you do. What is reasonable? The amount a similar business would pay for the same or similar services. The IRS wants you to receive a reasonable salary, rather than your underpaying yourself in salary then making it up through draws. Your accountant or a professional tax adviser can determine what salary is reasonable.
When your business is still new, you may decide to minimize your compensation and put the rest of what you would have earned back into the business. I understand. I have done the same when starting a business. Or you may decide it is time for a well-deserved raise. Whether you re-invest part of your salary or take a draw, ensure each transaction is recorded in the books. Do not treat your business account like a cookie jar, dipping into it whenever you like. Put yourself on the payroll.
Marvin Carolina Jr. is a vice president for JE Dunn Construction. He can be reached at firstname.lastname@example.org.