Small-business owners:
How much schould you pay yourself?

by Charlie Nash
Virginia Business
December 2005

Many people dream of one day being able to write their own paycheck so it’s ironic that business owners frequently pay themselves too little or sometimes, nothing at all. Instead, they plow their earnings back into their businesses. Even owners of established businesses sometimes underpay themselves.

As a small-business owner, you may assume that you won’t earn anything until the business gets firmly established. While this assumption appears logical, some experts will tell you that if a business doesn’t pay its owner a salary, its business plan and cash flow model are not being truly tested. Unless you operate under normal business conditions, and compensate everyone who works for the business, you can’t tell whether the business will be viable in the “real world.”

As a result, business owners should determine a minimum salary as early in the game as possible, preferably before operations begin. In addition, they should establish goals so that they can receive compensation more in line with their knowledge and skills, as well as the time they devote to the business. It’s also important to review the progress of a business toward its goals every six months to ensure that compensation figures are accurate and in sync with business conditions.

Some business owners have a tough time determining what their compensation should be. Determining how much to pay yourself can be emotional. However, as the owner, you’re the one taking the biggest risk if the business should fail. Logically then, you should earn more than your employees and if not, then you should ask yourself why. Are you making a short-term sacrifice to invest in future growth? It’s important to understand the reasons before making a final decision.

Because the cash flow of many businesses is unpredictable — especially during the early stages — you may want to consider relying on bonuses rather than a regular salary for much of your compensation. By doing so, you can determine when and how much the business can afford to pay you. Bonuses can come once or several times a year depending on your needs and the business’s performance.

Another factor to keep in mind is how the IRS will view your salary. For example, let’s say you own a C-corporation. The “C” simply refers to the tax treatment category your company is in. C-corporations are the most common traditional types of small businesses. You may face an unreasonable compensation audit if the IRS interprets the owner’s large salary as a disguised dividend. Because dividends, unlike salaries, are not deductible, an unfavorable determination could result in an overdue tax notice, back-interest charges and penalties for the business.

A good place to start is by talking to your CPA about what the IRS would consider reasonable compensation, as well as contacts at industry associations you belong to. If what you receive is out of line with what owners of comparable businesses earn, you could be setting yourself up for a visit from the IRS and costs could be substantial. Business valuation specialists may also offer insight into what a buyer would expect to be able to take from the business.

Once your salary is determined, don’t forget about saving for retirement. The amount you can save in a qualified plan is calculated based on eligible compensation. Therefore, when determining compensation, keep in mind that what you pay yourself affects how much you can save for retirement. Generally, the more you earn, the more you are able to save. Your financial consultant can help you develop a plan to address your retirement needs but it’s important to remain consistent and start as early as possible.

Charles Nash is a financial adviser and vice president at A.G. Edwards & Sons Inc. in Norfolk.