When payday rolls around at Out of the Woods Construction and Cabinetry in Arlington, MA, owner Greg Antonioli looks forward to cashing his paycheck just like his employees.
It hasn’t always been that way. Much like an estimated 30% of small business owners, there was a time when Antonioli did not take a salary. Instead, he would take periodic withdrawals from the company’s earnings.
Small business owners face the tough decision of how to structure their own compensation as their businesses grow.
“There is nothing worse than reaching six figures or seven figures a year, but only paying yourself minimum wage because, as the business owner, you pay everyone else first,” says Cortlon Cofield, a financial planner for business owners with Chicago-based Cofield Advisors. “You didn’t go into business to earn less than you did as an employee.”
Weighing two sides of the salary question
In taking a salary as a small business owner, you face important questions, such as:
- How much should you pay yourself?
- How and when will it be distributed to your bank account?
“I hear these questions often and my answer is, ‘It depends,’” says Cofield. “Because there are two sides to this question. You must weigh personal finances versus tax efficiency. Then you have to determine which is the right path for your specific situation.”
Cofield recommends weighing the pros and cons of taking a larger salary on an ongoing basis or going with no salary or a lower base salary that’s supplemented by distributions throughout the year.
To get to a final answer will likely require conversations with your tax attorney and financial advisor, but there are some key considerations to start thinking about now.
The larger salary approach
If it turns out your best move is to take a larger base salary, Cofield recommends that small business owners consider an approach developed by Mike Michalowicz in his book “Profit First,” which recommends setting up bank accounts for five categories:
- Operating expenses
- Operating expenses
Once established, all revenue first flows into the income account. Then it’s dispersed into other accounts based on pre-set percentages.
So, if you made $10,000 in a month and pre-set your owner’s compensation percentage to 40%, you would pay yourself $4,000 for the month.
“This allows you to be fairly compensated while still leaving money in the business to pay your taxes and bills, as well as for reinvestment,” Cofield says.
The tax-friendly approach
Depending on how your business is structured, there may be advantages to paying yourself a lower salary and then taking actions to boost your compensation in other ways.
As a business owner, you’re required to pay the full 15.3% of your self-employment taxes, while employees pay half of this amount.
- If you pay yourself a salary of $100,000, your self-employment tax obligation would be $15,300.
- Reducing your base salary to $40,000 would mean you only pay $6,120 in self-employment taxes, for a tax savings of $9,180.
- The additional $60,000 in revenue can then flow into your account as dividends, which would be taxed at a lower rate than salary-based income.
When to assess your compensation
Are you paying yourself enough for all of your hard work? Conversely, are you making sure there’s enough money to re-invest in your business or make it through a rough stretch?
The bottom line: It shouldn’t just be your employees who look forward to payday. Talk with your tax accountant and financial advisor to review how you’re paying yourself and if it’s the best choice for your situation.
Colfield advises reviewing your compensation plan annually. It also makes sense to revisit when there is a significant change to your business, or revenues either exceed or fall short of your projections by a significant amount.
This information is provided for informational purposes, may not be applicable to all situations, and is not intended to provide legal, tax, or financial advice. For specific advice about your unique circumstances, you may wish to consult a qualified professional.