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As a small-business owner, you naturally want to take home the fruits of your effort. But if you pay yourself too much, you run the risk of alienating employees or even depleting the amount of cash your company needs to remain operable and to grow. By taking too little compensation, you're shortchanging yourself for the hard work you put into your business, and you don't receive the return on investment—the promise of which usually drives many contractors to start their own business in the first place. In either of these situations, if you take too little or too much compensation, you may end up with tax problems that could signify the end of your hardwood flooring business.
Salary Strategies
The most obvious question to answer in determining your compensation is how much can your wood flooring business afford to pay? On the one hand, owners want at least some subsistence income from the business to meet their personal needs. On the other hand, the company may be able to afford little or nothing at certain times. For example:
• In a start-up situation, it may be a year or two before any payments to owners can be supported by company revenues.
• When a business experiences financial difficulties, it is the owner's compensation that typically takes the first hit if the company doesn't want to make drastic changes to ride out troubled times.
Often, an owner's compensation is adjusted on an annual basis according to profitability. The owner may receive a modest amount throughout the year, with a bonus reflecting the company's performance paid at year-end.
It's a good idea to incorporate your compensation into your formal business plan and tie owner compensation to revenue goals. The National Federation of Independent Business (NFIB) suggests that sole proprietors, for example, base their compensation on the business's profits over a two- or three-year period. To help you determine what the company can afford, you may want to use business-plan software (a good one is Business Plan Pro from Palo Alto Software, www.paloalto.com).
Remember to leave enough cash in the business to support continued growth. The NFIB advises that no more than half of profits be taken as salary so that the rest can be reinvested in the company.
Tax Issues
What you put into your pocket may depend in part on tax considerations. Here are some tax consequences if you are a:
• Self-employed individual: Your draw has no impact on taxes. Since you are taxed on your share of the company's profits, taking a larger or smaller draw does not change your income tax obligations. Similarly, for self employment tax purposes, you are taxed on your net earnings from self-employment so, again, your draw does not affect payments for Social Security and Medicare taxes.
• S corporation shareholder-employee: The typical strategy is to minimize compensation in order to minimize Social Security and Medicare (FICA) taxes paid by the corporation and you. Your share of profits is subject to income tax, but only actual salary payments are subject to FICA taxes. The IRS insists that you take "reasonable" compensation for services performed. There is no clear standard for making this determination; you should pay yourself what you'd have to pay an outsider to do the same work that you do.
Do a salary survey to determine the "going rate" for a person in your situation. Consider all the jobs you do for the business (financial controls, marketing, development, etc.) when making this determination, and compare your salary with rates of executives in the same industry as yours.
• C corporation shareholder-employee: The typical strategy is to maximize compensation to increase the corporation's deduction (and reduce the corporation's taxable income). However, only "reasonable" compensation is deductible by the corporation. Again, what's reasonable depends on the facts and circumstances. Small-business owners have successfully justified high compensation (when the corporation could afford it) after the owners had received little or no compensation in start-up or poor years.
In determining what to pay yourself, it's important to examine the financial implications of your decision. Ultimately, it's critical to find a balance between what is best for the company and what is fair to you.