And not just because you want to pay less in taxes. It’s good for you and your business.
All of the most successful small business owners I know take a salary from their business. And they also distribute profits to themselves when there is profit to be distributed. They don’t treat their business like a cash register, taking bills from the till whenever it strikes their fancy. Why? Because they understand something fundamental. They understand that in their business, they wear two hats. They have an employee hat and a shareholder hat. The employee is compensated for their labor, the shareholder is compensated for their share of ownership. Put another way, employees are paid a salary, shareholders are paid in profits.
As a small business owner, if you are actively engaged in your business, it is extremely advantageous to think of yourself this way – as wearing both the employee hat and the shareholder hat, and to pay yourself a salary, rather than just taking random ad-hoc distributions from your business whenever you feel like it. There are three primary benefits to this way of thinking: predictability, profitability and growth. I’ll go through each of these benefits below:
*Note: For purposes of this post, a “salary” should be construed as any regular, fixed distribution from the business to cover the living expenses of the business owner, whether through payroll or simple distributions. Some small business owners may see a tax benefit by electing to be treated as an S-corp and paying themselves a true salary through payroll (ie withholding federal, state and FICA taxes from their gross pay). I recommend speaking with a trusted tax advisor about the requirements and potential benefits of this type of tax treatment before pursuing an S-corp election for your business.
Back to the three reasons…
1 – Predictability.
Small businesses, like toddlers, thrive on a routine. Mess with a child’s routine enough, and the potential for a catastrophic meltdown becomes very likely. Your business is the same way. A predictable routine of monthly expenditures, which includes your salary, helps your business stay on track because you’ll always know how much cash your business needs to have on hand to continue normal operations and avoid the meltdown of racking up debt to keep things afloat.
On the flip-side, you and your family will be well served by the predictability of a salary because you’ll be able to base your budget on that amount and know that your normal expenditures will be covered.
2 – Profitability
Yes, taking a salary improves your profits. How? The discipline of paying yourself a predictable salary requires the rest of your expenses to toe the line. It requires focus on your finances and your cash flow that goes beyond the casual, glance-at-your-bank-account approach that many business owners take. Not focusing on your numbers and holding each dollar accountable is the biggest profitability mistake many of us are making. You can read more of my thoughts on this topic here.
3 – Growth
From the day you started your business, you had a director of sales, a director of operations, a marketing specialist, a listing agent and a buyer’s agent, right? Sure you did. You had all those positions open, and you filled all of them. Your salary in the beginning was essentially compensation for filling all of those roles. So as your revenue grows, and it comes time to replace yourself in each of those positions, you’ll know two things: First, you’ll have a sense of what you were paying that position before (a fraction of your salary), what the increase will be for leveraging it to someone else, and the return in revenue you’ll be expecting from that decision to leverage it to someone else. Second, you’ll understand that to keep the salary you had before, you can’t just hire someone and not see an increase in revenue as a result, that will sink your business. You’ll need increased revenue to justify it.
In a nutshell, the growth of your business will be directly tied to how effectively you replace yourself, and when you pay yourself a salary, you’ll already have a sense of what the business pays for that role.
Predictability. Profitability. Growth. Pay yourself a salary, and all three will come much easier to your business.