The two major ways entrepreneurs can take money from their business is through draws or by receiving a paycheck. The type of entity in which their business is set up will determine which method can be used. In either case, entrepreneurs need to be careful not to shortchange themselves.
Reasonable Compensation for a Salary Per the IRS
For small businesses formed as an S Corporation and with plenty of profits, reasonable compensation is a term you may want to be familiar with.
Many small businesses have organized as an S Corporation form of entity. In many cases, the S Corp election allows a business owner to save money on self-employment taxes, especially if they are operating as a sole proprietor. S Corp profits, or distributions, are not subject to payroll taxes.
If you are a business owner taking a salary and contributing substantially to the operations of the business, you may think that you should just take the distributions and forget the salary. After all, think about how much you would save in payroll taxes. But this has already been tried and shot down by the IRS in the courts. And this is where the term reasonable compensation comes in.
The IRS requires that business owners who perform a substantial contribution to the business be paid a salary according to a number of factors. This is called reasonable compensation. You can’t pay yourself below the market and take a large amount in distributions.
The IRS has issued a fact sheet that describes the guidelines that can be used to determine reasonable compensation. They include employee training, experience, duties, time spent, history of distributions, bonuses, and many other factors.
There are also reasonable compensation ramifications for C Corporations as well.
The 5 Things You Must Consider When You Set Your Own Salary
If you’re running a service business, it’s easy to initially think you can do well with a similar hourly rate that you earned as an employee. However, think of the amount of time and energy you are putting into your business every day of the week.
Here’s a quick list of five elements that should be included in the salary of every entrepreneur:
Competitive Pay
If you were doing the same work for a company that hired you, what would your payment be? Are you making at least the market equivalent or better? A lot of times, as entrepreneurs, we tend to focus only on this piece of our salary when we set our pricing, and that’s a big mistake. It’s only 75 percent of what our total pay needs to be.
Profit
As an entrepreneur, you take extra risks when you own your own company, and you should be compensated accordingly. Your capital is tied up in your business and should be earning a good return in addition to your reasonable salary.
Benefits
Employees get vacations, health insurance, and bonuses; and you should too. This should be part of your salary package as an entrepreneur.
Taxes
Although our individual taxes are not deductible as business expenses, we need to compensate for them so that we’ll have enough cash for our living expenses. It’s a huge chunk too. We work about three and a half months every year, just to pay for our taxes.
Retirement Plan
When you work for yourself, no one is going to fund your retirement for you. Although the Social Security program helps a lot of seniors, it’s up to you to set additional money aside for a comfortable future. The only way you can do this is to make sure you have given yourself a good salary.
Your salary should include all of these components. If it doesn’t and you feel like you can’t afford to pay yourself that much, then your pricing might not be reflecting all of these items correctly, you might have a volume problem, or your business model may need some adjusting.
It’s normal to take a smaller paycheck the first few years as we’re building our businesses, but if you’re still doing it after several years or constantly having cash flow issues, then something may be wrong.
I would be more than happy to chat with you about your salary, to see what changes need to be made to ensure you are getting the salary you deserve.
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Shannon Simmons, a 10+ year business owner, and 5+ year Profit First Coach is the owner of Netbooks Accounting Services, LLC. She is one of the original Profit First Professionals when the concept was created by Mike Michalowicz.
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