Pay yourself from profits
If you’re a new business owner, don’t make the common mistake of confusing revenue with profit. When you see money coming into your business, don’t assume you can pay yourself a big slice of that.
Before you take your cut, you need to first take into account things like taxes, payroll, fixed costs and overheads. This is why good accounting software is so important. It will let you keep track of all expenses and calculate profit rather than revenue or turnover. It will also help identify areas you can make tax deductions. Then you can quickly see whether your company is making enough money to afford to pay you.
Once you have the numbers, you can decide how much to pay yourself. There are no fixed rules about this, but here are some useful pointers.
Invest money for growth
Money you take out of the company (that doesn’t relate to your business) is money that can't be used for investment and business growth. You’re likely to be taxed on money you take out, so the real value of the money you keep in the company is even greater. That's because it will be untaxed or offset against tax, depending on how it's used.
If you think your business is going to grow in the future, it makes sense to use some of your profits to help that growth. The more money you invest sensibly into your business, the more likely it is that your company will grow. And that means you should be able to pay yourself more at a later date.
The more money you invest sensibly into your business, the more likely it is that your company will grow.
Pay yourself enough to live on
There's no point in being a complete miser with your company's money if it causes you financial problems. Personal money issues are a big cause of stress, and if you're stressed then you won't make good business decisions.
So it makes good business sense to pay yourself enough money to live comfortably without worrying. Take out what you need to avoid causing problems for your business.
Pay yourself regularly
Don't just dip into your business funds as and when you need to. Set up payments for you and your employees (it may be weekly or monthly) in your accounting software, and stick to them.
If you take out big sums of money at irregular times, it may raise eyebrows at the tax office. Build that into your business plan right from the start, perhaps with a rising salary as your business grows. That way you'll get used to the amount of money you receive and won't have to worry about taking out occasional large lump sums.
This will also look better to your employees. Regular small payments will be more acceptable to them than random large lump-sum withdrawals from the business. They will also look more acceptable to the government, too. If you take out big sums of money at irregular times, it may raise eyebrows at the tax office or lead to an audit of your company.
Take out ‘reasonable compensation’
Depending on where you live in the world, 'reasonable compensation' or a similar term may apply to you. This is known as the amount of money that the government expects you to take from your business. It depends on the size of the business, the market sector and level of turnover and profit.
Here are some pointers for what’s a ‘reasonable’ amount:
- How much would a similar business pay for similar services to the ones you personally provide to your business?
- What do recruitment ads and agencies offer to pay for someone in your position?
- Are your wages equal to your duties and are those duties being performed?
- Do your wages seem reasonable when you take into account of your level of responsibility and the amount of business you handle?
- Is your pay directly related to the amount of time you spend working?
- Does your pay seem reasonable when compared with your employees' wages?
Consider the legal structure of your business
How much you can pay yourself, and when, might be restricted by the legal structure of the business you run.
For example, if you’re a sole proprietor you’re usually free to pay yourself whatever and whenever you like. That's partly because you’re not accountable to shareholders or stockholders.
But other types of business, like incorporated businesses, usually have the business owner on the payroll. They would receive wages on a regular basis, just like any other employee.
However, the rules do vary from country to country, so check with your accountant before you decide anything. Be sure to record all transactions in your accounting software so you have an audit trail too. Do this just in case the tax office decides to investigate your payments to yourself.
Be tax efficient: Five pointers
Now you've decided how much is a fair salary for you, what’s the best way to withdraw that money from your business while remaining as tax efficient as possible?
There's no one-size-fits-all approach because tax laws vary from one jurisdiction to another. Tax rates and allowances will also vary depending on how your business is legally structured. Here are some ideas to consider:
Take a straight salaryIt's simple, easy to manage and account for, and is unlikely to raise any eyebrows. It's not always the most tax-efficient option, though.
Balance salary with dividend paymentsIf, as the business owner, you also own stock or shares in your company, you could take a minimal salary and then pay the remainder out of dividend payments. This can be more tax efficient (since dividends are usually taxed less than salary). Make sure you check the legality with your tax office first.
Take payment in stock or stock optionsThis can be a useful way of paying yourself in a tax-efficient manner.
Take a combination of salary plus annual bonusThis arrangement isn't just the preserve of the banking industry and it can be tax efficient in certain circumstances.
Create a business agreement to pay yourself laterIf you're not desperate for money right now, you could create a written business agreement to pay yourself later, deferring payment to yourself. But this becomes a liability for the company and would need to be accounted for.
Don't forget deductions, expenses and benefits
Leaving aside wages, there are some great financial benefits to running your own business. Medical insurance and 401(k) contributions are just two types of scheme to consider. They can make a big difference to your personal financial situation and they're legitimate business benefits.
Here are some examples of expenses that can be offset against the tax your company pays:
- Car expenses (business mileage of your car)
- Mortgage interest payments (if you work from your home)
- Capital equipment expenditure (such as new computers).
You're not usually allowed to claim expenses in the “personal, living or family expense” category. But you can claim for the business use portion of an item. This might mean you get to drive a new car in your personal life at a reduced overall cost. When in doubt, check with your accountant to find out what will work for you.
When not to pay yourself
If your business is going through a tough time financially, it’s usually not a good idea to take any money out of your business for personal use.
You should avoid taking any money if your employees haven't been paid. It looks bad, and would seriously affect their morale if you did.
When you owe a lot of money it's also wise to refrain from paying yourself a large amount. Creditors are unlikely to be impressed if you're still taking home a large pay packet while their invoices or loans remain unpaid.
Pay yourself fairly
Ultimately the amount you pay yourself will depend on the success of your business. The more money your business brings in, the higher the salary you could reasonably be expected to draw from it.
It makes sense not to get carried away and pay yourself too much, for reasons described. But if your company is profitable, there's no reason why you shouldn't reward yourself for that success.