There are many reasons for deciding to open a business. One reason that stands out, besides the chance to build your dream, is the opportunity to earn some serious cash. But when payday finally arrives, many owners make some easily avoidable mistakes. Here are the top five:
Failing To Consider Your Legal Business Type
Your business entity matters. The procedures for compensating yourself depend on the kind of business structure you choose.
If you're a sole proprietor, you don’t take a salary in the form of a regular paycheck. Instead, you are required to take a draw from your business. Partners in a partnership also don't receive a salary. They take distributions in line with their partnership or operating agreements.
If you're an owner of a corporation (C or S Corps), who actively works in the business, you are required to pay yourself reasonable compensation in the form of an employee salary. According to US law, you are required to be on the company payroll.
Failing To Understand IRS Requirements For Reasonable Compensation
If you earn a salary from the corporation, the IRS requires that you receive reasonable compensation. According to US law, you must make a reasonable amount for the particular job that you are doing. If you're getting paid $100,000 to do a job that typically pays $30,000, the IRS will naturally get a little suspicious. To help you determine what a reasonable salary is, the IRS has established a set of guidelines. Failure to understand these guidelines can lead to penalties.
Not Structuring Your Compensation For Better Financial Organization
To keep your business healthy and growing, owners juggle different responsibilities and make enormous sacrifices. Some owners avoid regularly paying themselves to keep more money in their business. Owners rely on savings, a second job, or money from their family. When times are hard, not paying yourself a salary or regular draw can be a useful way to save, but when you start turning a profit, and your business is growing, you should start paying yourself regularly. Regular payments will give your business a more accurate picture of net income and expenses. If you're seeking investment, paying yourself can also show that you are committed to growing your company and push you to increase your revenues.
Paying Yourself Too Much
When you start to see money running through your business, it can be tempting to grab a huge slice for yourself. But it’s important to take a sustainable amount that keeps your business financially healthy.
Before you take your cut, remember to account for taxes, payroll, fixed costs and any other overhead your business is required to pay. And remember not to confuse revenue with profits.
Failing To Consider Tax Implications
Whether you pay yourself a salary or take a draw, it's important to understand the tax consequences of your decision. Most small businesses pay themselves an owner’s draw. But draws are not taxed when they get taken out. Self-employment taxes get paid when you file your individual return, and you may want to consider quarterly estimated tax payments. On the other hand, if you earn a salary, your personal taxes will be withheld from each paycheck. Don’t forget your business will be paying the employer portion of taxes.
Either way, you will need to pay taxes no matter what payment method. A good understanding of your tax requirements will ensure you’re not stuck with a huge tax bill when you can least afford it.
Find more information on taxes and paying yourself as a business owner here.