How Much Should You Pay Yourself?

How much to pay yourself can be trickyHow Much Should You Pay Yourself?

As a small business owner, how much should you be paying yourself? I get this question all the time so I thought it would be better to address it in this manner.

Simply put, if you are a corporation (C or S corporation) you must pay yourself a “reasonable compensation”. The wages paid to yourself must be commensurate to your duties performed. Unfortunately there is no black or white answer to what is considered “reasonable compensation”. The reasonableness is based upon many factors such as the industry you are in, the amount of net income the business generated, the experience of the business owner, time involved in the business, formulas used to determine pay, etc.

This topic has become a hot topic over the past few years with the IRS because if you are not paying yourself enough salary, the earnings generated from the business would not be subject to payroll taxes. In this case you would save paying these into the government and only pay in the income taxes owed on your earnings. Additionally, under a tax audit, if the IRS determines the compensation you paid to yourself was too low, then they have the authority to “reclassify” withdrawals/dividends to salary and you would be responsible for past taxes due and penalties/interest.

If you are a sole proprietors or a partner of a partnership, the reasonableness test above do not apply, in general. The net ordinary earnings of a partnership are all generally subject to self-employment tax. Self-employment tax is similar to payroll taxes except that your share of this tax is not withheld each paycheck. You must calculate this amount and pay it in quarterly along with the ordinary income tax on your earnings. Also, instead of the corporation paying in 1/2 of the payroll taxes, you will be personally responsible for the full amount that is due. However, not all is lost as you get to deduct 1/2 of the Self-Employment tax against your income when the Form 1040 is filed.

Obviously taking into consideration the tax implications of payroll is wise. However, you must also consider what is best for the yourself personally and your business. Sometimes it is better to leave some money in the business to facilitate growth rather than take every penny out. This is something you can discuss with your accountant or controller to determine the proper amount.

As you can see, if you don’t understand the implications of taking money out of your company, unexpected consequences can and will occur.