As much as entrepreneurs love their careers, most would admit that it’s a lot harder than it looks. The life of an entrepreneur differs tremendously from the average employee. It requires many sacrifices, like working tirelessly for very little in return. People tend to associate entrepreneurs with vast wealth. What they don’t know is that new entrepreneurs don’t get paid the same way as everyone else. Like every other aspect of the business, entrepreneurs must determine their own salaries, or whether they should be taking one at all.
This is one of the most complex issues for new entrepreneurs. It’s very difficult to ascertain if the salary you’re taking is too big or too small. Every business is different, so there’s no right answer. But in most cases, you should be taking a salary, and it should probably be on the lower side.
In this guide, we’ll go over each factor to consider when determining your personal salary as an entrepreneur along with the various methods of paying yourself.
How Much Do Entrepreneurs Make?
The IRS requires business owners to compensate themselves based on the structure of their businesses. Most entrepreneurs pay themselves with one of two methods: the salary method and the owner’s draw method. The former method is similar to the payment structure of the typical full-time employee. With the owner’s draw method, on the other hand, the owner’s salary is a portion of the company’s profits.
What is the Average Entrepreneur Salary?
When deciding how much to pay yourself, it makes sense to consider what the average entrepreneur earns per year. A great deal of new entrepreneurs reportedly don’t pay themselves at all. But that doesn’t mean you have to follow this trend. According to recent data from Payscale, the average salary for a US-based small business owner is currently a little over $71,000. If you look deeper into this data, however, you’ll find that the average entrepreneur makes considerably more than that in several major cities. This reveals one major factor in your salary: location.
The main takeaway here is that the average entrepreneur salary is not high. If so many entrepreneurs are earning subpar salaries, what keeps them motivated? As cliché as it sounds, this data proves that most entrepreneurs do what they do because they simply love doing it. There may be serious potential for getting rich, but money is clearly not what motivates America’s entrepreneurs.
Why Should an Entrepreneur Take a Salary?
When you’re starting a new business, personal compensation is probably the last thing on your mind. In fact, this is one reason lots of people choose the entrepreneurial path to begin with. They want to focus entirely on helping their customers and making money for their business, not themselves. Entrepreneurs often work tirelessly into the night and on weekends, despite knowing they will receive no monetary reward. But your plan is not complete unless you figure out how to compensate yourself and when you’ll start taking an appropriate salary. This issue needs to be addressed even if your business is not fully operational just yet.
Your salary depends on a multitude of factors like industry, time in business, and cash flow. Due to the amount of components at work, your recommended salary may end up being drastically different than other new entrepreneurs in your industry, or other entrepreneurs with the same number of employees.
Only after taking these factors into account can you determine the right salary calculation method for you as well as the frequency for paying yourself. Each calculation method and frequency has pros and cons, including legal implications.
Step 1: Separate Your Personal and Business Finances
The process of determining your salary cannot begin if you are yet to separate your personal and business finances. Most accountants would advise new entrepreneurs to do this before making their first sale. It’s extremely common for entrepreneurs to mix personal and business finances when covering initial startup costs. This makes it very difficult to accurately track your business’s income, expenses, cash flow, and profitability. All of these things must be considered to determine your salary as well as your tax payments. The lack of a business bank account could prevent you from receiving certain deductions, and it’s nearly impossible to obtain a business loan without one.
Some banks, however, have numerous requirements for opening and maintaining a business bank account. New businesses may have trouble meeting minimums for monthly deposits or daily balances, and failing to do so could result in fees. If you don’t want the stress of opening an account at a second bank, consider simply opening a second personal bank account. There’s no rule that says you can’t use this account exclusively for your business.
Another way to keep personal and business finances separate is a business credit card. You can make monthly payments from your business bank account and build credit in the process.
Step 2: Choose Your Type of Salary
Now that you’ve separated your personal and business finances, you can move on to exploring the different types of compensation.
The first factor to consider is business structure or entity. Is your business a sole proprietorship, general partnership, limited liability company, etc.? The IRS has different requirements for how owners of each business entity should be compensated. So, as you move forward, make sure you are in compliance with your entity’s legal rights and obligations.
Once you’ve read those over, it’s time to whether you’ll pay yourself through the salary method or owner’s draw method.
The Salary Method
The salary method pays you at a fixed interval like the rest of the workforce (usually bi-weekly). Thus, your paycheck is either a flat amount or determined by how many hours you worked in that interval.
According to the legal obligations from the previous section, officers of C-corporations (CEO, COO, etc.) and owners of S-corporations must be compensated through the salary method. These obligations also state that their paychecks must include deductions for Social Security, Medicare, and federal and state income taxes.
The Owner’s Draw Method
The owner’s draw method takes your salary as a percentage of the company’s profits, but only the profits and not revenue. Since profits are the difference between revenue and expenses, you must account for all business expenses, even payroll and employee benefits. All of the data you need to make this decision can be found on your business’s profit and loss statements. This will tell you how much you can afford to draw from your business’s profits, and how often you can afford to take that amount.
Business owners who use this method are not legally obligated to withhold for Medicare, Social Security, or federal and state income taxes when they take their paychecks. Come tax season, however, you’ll still have to report that income and pay the equivalent taxes on it. You must therefore keep accurate records of your own income and consistently put money away for your upcoming tax payment. Several popular accounting tools can handle both tasks for you.
Unlike corporations, all the revenue that’s left over after deducting expenses for sole proprietorships, general/limited partnerships, and LLCs is viewed by the IRS as the owner’s income. In other words, there’s no law against taking all of your company’s profits for yourself, whether it’s through the owner’s draw method or the salary method. You can basically pay yourself however you want, almost as if you were self-employed.
3. Understand the Advantages of Paying Yourself
Taking a personal salary carries numerous benefits aside from having more money in your own pocket. It shows your employees that your own financial stability now depends on the success of your business. Reporting your salary to the IRS also proves that your business is earning more money than a side hustle or passion project. In summary, taking a salary reflects your heightened commitment to your business’s future.
It is often recommended to begin taking a salary as early as possible, even if you’re paying yourself very little. Figuring out how much money you can afford to take for yourself provides a deeper insight into your operational costs. You have a better idea of what you can spend on necessary, growth-related expenses moving forward.
For these reasons, all entrepreneurs should not go too long without paying themselves. That includes sole proprietors and partners, both of which are not legally required to take personal salaries.
What is Your Definition of “Reasonable Compensation?”
If a business owner chooses to take a salary, the IRS states that the business owner should receive “reasonable compensation.” This refers to a salary that is comparable to the salary of an employee at another business who has similar responsibilities.
Since this definition isn’t much help, you’ll have to think more about what truly constitutes “reasonable compensation” for your financial circumstances.
You can start by examining the cost of your essential living expenses, like rent, food, car, etc. How much do you need to spend on these expenses in a given month? Next, check sites like Glassdoor to see estimated salaries for highly ranked positions in your industry. Arguably the best way to determine your definition of “reasonable compensation,” however, is to talk to your more successful competitors. Other entrepreneurs in your industry have been in your position before and can tell you if the salary they paid themselves at the time was too high, too low, or just right.
When reviewing your living expenses, you may find that some bills tend to fluctuate throughout the year. In this case, the owner’s draw method might be a better choice than a fixed, annual salary. Your salary would fluctuate based on your business’s profits. But this method only makes senses for fairly established businesses that have been generating a steady profit for some time. If your business has an especially successful year and generates more profits than usual, you can simply take a larger portion as a bonus.
How Often Should You Get a Paycheck?
Before solidifying your salary amount, it’s important to determine your paycheck schedule. Like your amount, your paycheck schedule should essentially be the same as that of an employee with similar responsibilities at another business.
Most employees get paid once a week or bi-weekly, though some startups do give monthly paychecks. Luckily, this is one question you can leave to your accountant. Don’t just assume that bi-weekly is best because that’s what everyone else does.
Business owners that use the owner’s draw method must keep an accurate record of their pay days. The IRS might get suspicious if they see an inconsistent schedule of draws and possibly even audit your company. Your payment record will also provide a clearer picture of your business’s cash flow, revenue, and of course, profits.
4. Calculate Your Salary
Now comes the fun part: figuring out what number is actually going to appear on your paycheck. Once again, this depends on a host of factors and therefore varies tremendously from business to business. Instead of relying on an existing equation, it’s your job to figure out which numbers to plug in. Thus, you can calculate your compensation by assigning numbers to each of the following factors:
Determine the Market Value of Your Position
We’ve mentioned comparing yourself to an employee with similar responsibilities several times. It’s difficult to envision this scenario because most business owners have a myriad of responsibilities: customer service, sales, marketing, etc. After looking at other peoples’ job descriptions, you might conclude that even the highest ranked employees in your industry have fewer responsibilities than you.
If so, you’re in luck. Finding a matching job description isn’t the only way to determine the market value of your position. Instead, make a list of your most common day-to-day responsibilities. Then, consider what it would probably cost to outsource these responsibilities to multiple people. Combine each payout to find your “true wage,” as it’s sometimes called.
Account For Tax Pros And Cons
One reason many new business owners don’t pay themselves at all is that from a tax standpoint, the advantages clearly outweigh the disadvantages. To determine if you fall into this group, consider your business entity and whether it’s best for you to use the owner’s draw method or salary method. Depending on these two factors, there could be more tax benefits to reinvesting most of your profits into your business rather than taking a full salary.
Of course, it’s your accountant’s job to know which tax regulations have the biggest impact on your company. Reinvesting most of your profits could minimize your tax burden, not to mention increase your eligibility for the most desirable business loans. Traditional institutions like banks are historically biased towards applicants with “skin the game.” In their eyes, people who invest in their own businesses are less likely to let those businesses fail.
Your accountant could also present strategies in which the bulk of your salary comes from capitalizing on certain deductions and tax breaks. Ultimately, the two of you will decide whether taking a smaller salary offers more pros than cons for your business.
Account for Your Employees’ Compensation
New entrepreneurs often pay themselves less so they can continue to offer competitive salaries for early-stage employees. It’s especially critical to not pay yourself too much if you attracted these employees by promising bonuses or equity once the company gains traction. But you don’t want to pay yourself too little. This could cause employees to question your commitment to your business, since it’s apparently not your only source of income.
Account for Cash Flow
Cash flow affects your salary in at least two ways. First, your salary cannot inhibit your ability to cover regular business expenses, like payroll or inventory. It will likely take time for your business to become profitable. When this time comes, your profits must be substantial enough to cover steady increases in recurring expenses as well as your own salary. In other words, your business probably isn’t generating enough profits if you still can’t pay yourself a decent salary without endangering cash flow.
Neglecting to pay yourself cannot be one of the main reasons your business is able to stay alive. If this is the case, your business’s days may be numbered if you don’t look into the various solutions for raising profits.
How Fast is Your Company Growing?
Business growth requires you to think about the future. As mentioned in the previous section, your business will need an increasing amount of working capital to meet its goals for expansion. Therefore, the salary you choose for yourself cannot interfere with the associated expenses. What you have to ask yourself is, how soon will these expenses arise?
If your business is on track for rapid growth, your salary should probably account for your upcoming boost in spending. You may find that you can’t even afford to give yourself a salary right now because of your new expenses. During this crucial stage of your business’s development, you might want to hold on to as much working capital as possible.
And while it might not happen right away, growth is supposed to eventually increase profits. You might decide to begin paying yourself when you reach that goal, which will also give you access to highly advantageous business loans.
Can You Afford a Lower Salary?
An earlier step asked you to analyze your cost of living. This step is similar, but instead of just listing your expenses, you must now consider how you pay for them. Are you currently able to afford these things with little or no personal salary?
Most entrepreneurs who don’t take a salary are only able to do so because they already have enough money to support themselves in the long term. They might have to cut back in a few areas but refusing to take a salary won’t have much effect on their lifestyle. Some people would even say that if this doesn’t sound like you, entrepreneurship just isn’t feasible at all.
If you do need your own income to cover your expenses, it’s crucial to address this need immediately. As an entrepreneur, you have plenty of business expenses to worry about. You won’t be in the right mindset to run a business if you have to add your own expenses to that list.
Entrepreneur Salary: What’s Best for Your Business?
There’s no denying it. The salary you choose for yourself will have an emotional effect. But regardless of how you feel, you cannot let your emotions stop you from doing what’s best for your business. And remember: Your business cannot survive with its leader. Though this is technically your personal salary, you’re really just figuring out how much it costs to maintain your business’s most important asset: you.