As a small business owner, it takes a lot of time and commitment to run and grow your business. With all the work you put in, it’s hard to measure how much you should earn as your small business owner salary. In this guide, you’ll explore what a small business owner salary is, how much you should earn, as well as distributions; how to make them, and how you should be using them.
Why does your small business owner’s salary matter?
Earning a salary from your business may be the least of your worries as a business owner – you may even use all the funds to invest in the business further instead of paying yourself. However, earning an appropriate salary is extremely important for you and your business. Your small business owner’s salary supports your:
- Viability: Setting clear requirements for your business to pay you determines whether the business is worth running. If your business isn’t paying you enough to make a bare minimum income now and is unlikely to within the next year, it’s not worth continuing to work on your business full-time.
- Budgeting: Your small business owner salary makes budgeting your money a lot easier. When you treat your earnings from the business just like any other expense that must be paid every month, it’s easier to stop your business’s spending from eating up your income.
While you might not pay yourself from the business, but essentially “live off” the business by charging your personal expenses to the business, this is not a good idea. You’ll want to keep your business and personal finances separate because this spending is uncontrolled and unorganized. Paying a regular salary each month lets you know what the business is worth to you and represents a goal your business needs to hit monthly.
How to determine your small business owner salary
1. Your cost of living
The most common method of calculating your small business owner’s salary is by setting it equal to your cost of living. To do this, it’s a good idea to look at your entire household’s expenses as well as other sources of income. You can use this template to guide you on this calculation.
Before getting started, it’s important to note that there are a few considerations to your financial situation as a business owner that are different than if you’re employed in a job:
- Health insurance: You’ll generally have to pay for your own health insurance. Even if your business directly pays the bill, it most likely isn’t a deductible business expense.
- Taxes: You will be responsible for your self-employment taxes and income taxes, but this will vary depending on the type of entity that you’ve set up – either a sole proprietorship, a limited liability company (LLC), or a corporation.
Using the template, you’ll fill out the left column with the annual amount of all your and your spouse’s income, and then fill out the right column with the annual amount of all your and your household’s expenses.
Here’s an example:
- You and your family earn $38,000 annually – not including the business – and spend $127,200 annually. This means that if you are working full-time, the business must pay you at least $89,200 per year or just over $7,400 monthly. This is referred to as your bare minimum income or your cost of living.
Based on this, you’ll need to budget carefully to see how much growth and revenue your business needs to achieve this salary within one year. If that’s not possible, you might need to reconsider whether you want to keep running your business.
Once your business can cover your cost of living, you’ll need to establish your market rate above that.
2. Your market rate
The second method is the market rate technique. It looks at what you’ll be “worth” in another job. Here are the steps to follow:
- First, you’ll search for your position and seniority at several other businesses, focusing on the salary. Then, calculate the average salary for these jobs, and you’ll have your market rate.
- Second, you need to consider your opportunity cost. Opportunity cost measures what you could be missing if you choose another option. For example, the opportunity for advancement in a job and the opportunity to do more interesting and rewarding work through owning your own business.
It’s important to know that when you calculate your market rate, you should look at it as an hourly rate, so it’s measured by the number of hours you work in your business. This is because a $100,000 job might not have nearly as many hours as making $100,000 from your own business.
What if your small business owner salary isn’t enough?
Not every business has enough profitability and cash flow to support the cost of living or market rate income right now, but you may be able to in the not-too-distant future. You should understand exactly how much work it will take to achieve. You can do that in 3 steps:
- Calculate your gross margin, which is your gross profit divided by your sales.
- Add up your monthly fixed expenses, debt and loan payments, and cost of living or market rate.
- Divide the results of number 2 by number 1.
This will give you the exact amount of monthly sales you need to break even – not only on your expenses but also on paying your small business owner salary. Then, you’ll need to look at how much customer growth and how much time it will take to achieve that level.
It’s important to note that your business’s value is not always based upon the profits it pays out each month or year, and some businesses may create the most value when they are merged or acquired. This might very well be the case for your business, too, but make sure you aren’t using the long term value as an excuse for not paying yourself enough in the short term.
How to pay yourself with distributions
You’ve likely heard of distributions related to your business, maybe in conversation with your accountant, among other business owners, or on your tax paperwork. Distributions are a key strategy to paying your small business owner salary. Before you understand how to pay yourself with distributions, you should understand what distributions are and how they work.
What are distributions?
Distributions are used to pay you your share of your business’s profits and earnings, and it is often referred to as your pay or salary.
Knowing the concept of distributions and how to make them can help you take as much financial reward from your business as is reasonably possible.
Where are distributions on my financial statements?
Although it seems like your small business owner salary should be an expense that’s listed on your profit and loss statement, distributions are actually listed on your balance sheet. This is because distributions have no effect on your business’s profitability or the amount of taxes your business will pay.
Distributions are made to you by taking cash out of the business from retained profits or cash that investors put into the business. You’ll see it show up on a cash flow statement or a balance sheet, but not a profit and loss statement. When it’s time to prepare tax returns, distributions show up in two important places:
- On the business side, distributions show up on the balance sheet section of your tax return (total distributions since the business started) and in Section M-1, which shows distributions that have been made throughout the year.
- For business owners, distributions and dividends show up on the form K-1 that you receive from your business. This document is used to prepare your personal taxes.
What’s the difference between a distribution and a dividend?
Most small businesses are limited liability companies (LLCs) or S-Corps and aren’t likely to have dividends. Distributions are a payout of your business’s equity to you and other owners. That means they can come from the accumulated profits or from money that was previously invested in the business, and they’re not factored into how much you’re is taxed.
Dividends come exclusively from your business’s profits and count as taxable income for you and other owners. General corporations, unlike S-Corps and LLCs, pay corporate tax on their profits. Distributions that are paid out after that are considered “after-tax” and are taxable to the owners that receive them.
Any legitimate shareholder or LLC member is eligible to get distributions. Generally, any time distributions are paid, everyone who is eligible to get them must get their share. That means in a four-equal-partner business, for one partner to receive $1,000 in distributions the business must pay out $4,000 in total with $1,000 going to each of the four partners.
How much can my business pay in distributions?
Choosing how much to pay in distributions can be as complicated or as simple of a choice as you want. On the most basic level you can follow these rules:
- Pay less in distributions than your business made in profits in a period.
- If your business is not profitable, don’t pay any distributions.
- Even if you have profits to pay out, make sure you hold on to permanent working capital, or a cash reserve.
Breaking any of the above rules can put you in a difficult position if you end up needing a loan to grow your business, which most businesses eventually do. If a lender discovers that you’re paying more in distributions than the business’s profits should allow, or if you aren’t holding on to a cash reserve, you could be placing your business at risk of being denied for a loan.
On a more advanced level, the way that your business pays out distributions might be set in your charter documents (bylaws or an operating agreement). Generally, the rules above still apply, but charter documents get much more specific about:
- How to calculate your profits that are available to pay out in distributions
- How much to reserve for any corporate, state, or local taxes
- How much permanent working capital reserve your business needs
- How much to hold onto to build permanent working capital
- How often distributions are paid (usually quarterly or annually).
- The use of accelerated distributions – distributions that are paid at a faster rate to some investors or owners as an incentive for them to be part of the business.
Ask your accountant for advice on distributions
Distributions are something that you should be aware of as a business owner and should know enough about to be able to pay throughout the year. You’ll likely want your accountant’s advice and insight, too. An accountant can help you determine the following:
- How much of the payments made out each year can be counted as distributions
- How to make sure each owner’s capital account is adequately maintained
- How to make other payments from your business, like salaries or guaranteed payments, that might be more effective for tax purposes.
Be smart with your small business owner salary and distributions
There are many reasons why you might want to own your own business. The appeal of being one’s own boss is powerful, and once your business is profitable, taking distributions can be quite lucrative.
However, you need to make sure your business is worth it. It may take years before your business is profitable enough for you to even be able to take a distribution and earn enough income to support your cost of living. If you wait until the time and business is right, you’ll experience the profitable benefit of owning a business, while still maintaining your business’s solid financial footing.
Pursuit has financing available to help your business grow
Pursuit is a leading small business lender throughout New York, New Jersey, Pennsylvania, Connecticut, Illinois, Nevada, and Washington. We have a line of credit and loan options that can help you meet your business needs and support growth projects.
Contact us to learn more about how we can help you grow your business.
