In your business, employee payroll probably runs like a well-oiled machine. But, as the business owner, how can you be sure you’ve devised the best plan to pay yourself?
Creating a fair owner’s compensation plan for yourself can be a process that’s fraught with both high-stakes emotions and highly complex tax implications. Fortunately, we’re here to help break down the basics for you.
By understanding these essentials, you can begin to pay yourself more strategically, without having to wonder if you’re sacrificing your business’s future, your staff’s morale, or your own wellbeing.
Owner’s Compensation vs. Executive Compensation
First things first, it’s important to note that paying yourself as a business owner is not the same as executive compensation. The purpose and objectives are fundamentally different. Here’s how it typically plays out:
- Who Gets Paid: Owners’ compensation refers to the financial rewards that business owners or shareholders receive for their ownership stake in the company. Executive compensation, meanwhile, refers to the financial package and benefits provided to top-level executives (think COO, CFO, Senior VPs) as compensation for their managerial roles and responsibilities within the company.
- Why Its Paid: Owners’ compensation serves as a return on investment to owners who have invested in the company, whereas
executive compensation is designed to attract, retain, and incentivize key executives to lead the company effectively. - How Its Determined: The amount an owner is compensated is directly tied to the success and profitability of the business. Executive compensation is also often tied to the company’s performance, but it also factors in the executive’s position and his or her individual, on-the-job performance.
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Want to learn more about managing your executive compensation plan? Our Certified Financial Planners® can help you make the most your executive compensation plan benefits now so that you can be ready for good. |
3 Questions to Ask Before You Pay Yourself
Before you can determine how you are going to pay yourself as a business owner, you have to answer a few critical questions. Your answers to these questions will greatly dictate your owners’ compensation strategy.
A good financial planner will guide you through each of these questions to help you create a comprehensive and nuanced plan that accounts for all the gray areas that come with business ownership.
What is the size of my business?
While your financial metrics like EBITDA and adjusted gross income are obviously important, you also need to consider the size of your business from a human perspective. For example, do you have key team members you need to retain through competitive compensation packages? How are your staff’s salaries and benefits expected to evolve in the coming years?
How is my business legally structured?
The more complicated your business structure, the more complicated owners’ compensation can get. If you’re a sole proprietor, for example, it can be fairly black and white: everything the business makes is typically reported as the business owner’s taxable income.
On the other end of the spectrum, a legal structure like an S corporation brings with it more tax rules (like the IRS’s reasonable compensation rule), but also more compensation tools that can help you reduce your taxable income.
What are my goals as a business owner?
This may be the most important question of all. Do you have long-term plans for staying in the business and want to continually reinvest in it? Are you looking to sell in the next 3-5 years? When you do you intend to retire? The milestones and deadlines you set for yourself will dictate the best way to pay yourself, too.
6 Tools to Pay Yourself as a Business Owner
“Should I take an owner’s draw or salary?” is perhaps the number one question we get when working with our business owner clients. But it’s important to know that those aren’t your only options. Let’s look at the five most common compensation tools business owners
use to pay themselves.
1. Salary
One of the most common owner’s compensation options is to pay yourself a salary as a business owner. This method involves setting a regular salary amount and being treated as an employee of the business. By receiving a salary, you can ensure a consistent income stream and potentially qualify for certain employee benefits. From a tax planning perspective, keep in mind that any salary payments you make to yourself are subject to payroll taxes, including Social Security and Medicare taxes paid out by both the employee (you) and the employer (you again).
2. Owner’s Draw
In an owner’s draw, you’re choosing to withdraw money from the business’s earnings as needed without formalizing a salary structure. Owner’s draws are typically not subject to payroll taxes, making them an attractive option for tax planning purposes. However, it’s important to note that taking excessive draws may have negative tax consequences and can affect the financial health of your business.
3. Bonuses and Profit Sharing
Business owners can also opt to reward themselves with bonuses or profit sharing when the company performs well. Bonuses can be given as a percentage of company profits or based on specific performance metrics. Profit sharing, on the other hand, involves distributing a portion of the company’s profits among the owners.
From a tax-planning standpoint, bonuses and profit-sharing distributions are generally tax-deductible for the business and taxable (as income) for the recipient. However, there is another angle to consider: 401k-based profit sharing. By distributing profit-sharing funds directly into your (and your employees’) 401k plan, your business can earn the same tax deduction while also deferring all the income taxes you would have otherwise paid on a straight cash distribution. For more information, check out the IRS’s guide to profit-sharing plans for small businesses.
4. Qualified Deferred Compensation Plans
Deferred compensation plans are exactly what they sound like: you’re deferring—aka postponing—today’s income for a later date. This has the dual benefit of helping you save for the future while also reducing your taxable income in the here and now.
In general, there are two types of deferred compensation plans: qualified and non-qualified. A qualified deferred compensation plan is essentially any employer-sponsored retirement savings plan that’s protected under the Employee Retirement Income Security Act
(ERISA) of 1974, such as a 401k, a simplified employee pension (SEP) IRA, or a Savings Incentive Match PLan for Employees (SIMPLE) IRA. As a business owner, you’re subject to the same privileges and rules as your employees when it comes to contributing pre-tax or tax-deductible funds into these retirement vehicles.
5. Non-Qualified Deferred Compensation Plans
More commonly known in the corporate world as supplemental executive retirement plans or elective deferral plans, non-qualified deferred compensation plans are any deferred comp plans that do not fall under the protection and purview of ERISA. This has its pros and its cons.
In the “pro” category, you have a lot more flexibility and control. There are no contribution limits, no required minimum distributions, and no age restrictions on withdrawals. This makes it an ideal owner’s compensation tool for business owners who have a very healthy
cash flow.
On the “con” side, however, there can be considerably more risk. Unlike qualified plan funds, which are required by ERISA to be held outside of the company in a separate trust, the funds in a non-qualified plan often live on a company’s proverbial ledger. That means those funds could be lost should the company hit hard times. Working with your attorney and financial planner to make sure your non-qualified plan is set up to protect you should be your top priority.
6. Equity Compensation
Equity compensation, such as granting shares or stock units, provides ownership stakes in the business with the potential benefit of future growth in value.
Like qualified deferred compensation plans, equity compensation can be smart way to simultaneously pay yourself and control your employees’ compensation packages. Opening up equity compensation to your staff frees up a portion of your cash flow from payroll
while helping your employees gain an “owner’s mindset,” which can have a tremendous impact on staff productivity, efficiency, and retention.
It goes without saying that equity compensation plans can have significant tax implications and require a level of set-up that’s a bit more complex than opening up a 401k. Be sure to consult with your financial, legal, and tax advisors to navigate the process.
Find an Advisor Who Can Help You Pay Yourself Wisely
Simply put, figuring out how to pay yourself as a business owner requires examining a lot of variables and weighing a lot of options. And, if you’re like most business owners, you simply don’t have the time to do that level of due diligence.
That’s why the best place to start is by finding a financial advisor who can understand all the complexities of your business, will take the time to educate you on your options, and will proactively work with all your other business advisors as your financial “quarterback.” You’re putting your heart and soul into building your business—it’s only fair that you have someone in your corner making sure you’re
paying yourself fairly.
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Get Help Now Our Certified Financial Planners® can help you build an owner’s compensation strategy and financial plan that maximizes your tax savings, your cash flow, and your peace of mind. |
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