Be your own boss; fill a need in your community; determine your income; pursue your passion – there are countless reasons that inspire people to run their own business. But regardless of what prompted a person to go the route of self-employment, there’s one thing every business owner must figure out: How much to pay themselves.
Striking the perfect balance is crucial. On one hand, you need to reinvest enough of your profits in your business to keep it healthy and moving forward. On the other hand, you need to pay your own bills and buy groceries.
Know your tax status
You may be surprised to find that you have less control over how much you can pay yourself than you thought. Different business structures have different rules about self-payment, Constant Contact explained.
If you’re a sole proprietor
or a one-person limited liability corporation, you’ll find your compensation on line 31 of Form 1040, Schedule C. There’s no formal paycheck needed, but the listed amount is what you’ll pay Medicare and Social Security taxes on.
If you’re a partnership
or multi-person LLC, you’ll file Form 1065, U.S. Partnership Return of Income. Each partner will receive the Schedule K-1 form, which helps them determine and report their share of income on Form 1040.
If you’re a corporation
you’ll get paid a salary like any other employee. You also have the option to claim dividends either instead of or in addition to your salary. However, be cautious balancing the two; some business owners make strong efforts toward maximizing dividends and minimizing salaries for their own personal gain, a practice the IRS isn’t too fond of.
Consider business health
Once you’ve determined how your business will be viewed through the lens of the IRS, it’s time to think more granularly. Starting and maintaining a business requires cash for things like office supplies, inventory and employee paychecks. It’s important to determine how much these necessities will cost, and that you’re reserving enough money to cover these expenses.
Another important expense to keep in mind is taxes. While you may not know how much you’ll be taxed come April, it’s best to plan ahead as well as you can. Calculate your best estimate and set aside some revenue each month so you have a pool to use when tax season comes around.
Just like any other entity, a business can suffer unexpected damage or an unfortunate turn for the worse. You may have a personal emergency fund to help you cover sudden expenses like a new car after your old jalopy bites the dust or medical bills after an injury or illness. Apply the same concept to your business – have an emergency fund to help you weather challenges like a supplier who won’t deliver or a natural disaster leaving your shop worse for the wear.
Know your worth
Many entrepreneurs open their own businesses in hopes that they’ll be able to make more as a self-employed person than simply an employee at someone else’s company. While you probably won’t be able to boost your salary during the first year, or at least before your company breaks even, it’s important to know how much you’re worth. Entrepreneur recommends using a calculation to determine your basic worth:
Begin with your market worth – your current salary or hourly wage. Then, calculate how much you make in a month.
Next, determine the rate of inflation; in 2017, it’s expected to be 1.4 percent, according to Kiplinger. Take that amount and multiply it by 4: 5.6 percent.
Finally, multiply your monthly wage by 5.6 percent to get your basic worth.
Once you’ve figured this out, however, it’s important to evaluate your basic worth to determine if it’s right for you. Will it cover your living expenses? Conversely, will it leave enough money to sustain the business? Your basic worth is a good starting point, but not necessarily a perfect model.