Tuesday, January 20, 2009

How Much Should I Pay Myself?

Entrepreneurs and business owners often ask and wrestle with this question. We need to consider your replacement income, your monthly "nut," and your entity's tax structure to begin to answer the question.

The first factor to consider is the cost to replace your position in the company. It is very important to not confuse business ownership with business employment. If you are the President and CEO of the company, then what are Presidents and CEOs of other companies like yours earning as a salary/wage every year. Again, please separate ownership from wage. In most companies the entrepreneurs tend to under compensate themselves relative to their peers, mainly because they are in what is called "cheap labor, high productivity" mode.

Next we need to consider what you need personally to survive. I listened to a successful entrepreneur give a 30-minute speech about 6 months ago and I had one major take-away. He articulated that entrepreneur's need to make sure they are making enough to pay their personal bills and cover their personal expenses in order to be the most effective at growing their companies. If all we are ever concerned with is how are we going to feed our family next week, the business suffers.

With these two factors under consideration, we should be able to arrive at a reasonable and fair compensation plan. Maybe it is $50,000 per year, or maybe $100, 000, or more. If the number is higher than the company can afford, then we need to figure out how to get the company to where it can afford to fairly compensate the entrepreneurs and owners. If the business will never be able to feasibly afford them, then we may need to consider drastic alternatives - like starting another business or re-entering the workforce where we can receive compensation commensurate with our contributions to a company.

The last consideration is how to receive the compensation. Your company's tax classification will best determine this. Please check with your tax adviser before implementing any of these strategies. If you are a sole-proprietorship or a dis-regarded entity filing on schedule C of the 1040 form, then you just pull money out of the business at regular intervals, or you can pay yourself as an employee, or some combination of both. All of your earnings will be subject to self-employment tax. If you are taxed as a partnership (Form 1065) then you will most likely have to pay self-employment tax on all of your earnings. Hence, you can select any of the forms of payment mentioned for sole proprietors, the only difference being that profit distributions will most likely be treated as guaranteed payments. If you are taxed as a C-Corporation, then you must take a w-2 wage and you may be able to loan yourself some of your compensation. If you are taxed as an S-Corporation, then you will most likely receive a portion of your compensation as an employee and a portion as a distribution (which is not subject to self-employment tax).

In conclusion, a fair and reasonable wage for the entrepreneurs is a critical part of the business plan and should be reviewed regularly.