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as your business grows you're eventually going to be faced with a hard decision and that decision is around pay no i'm not talking about paying your employees so take a breather this time is all about you you need to decide how you're going to get paid and when but you're probably wondering what is the best salary for small business owners i mean how do you decide how much to pay yourself and what is the best method to pay yourself for example there are owner draws dividends distributions w-2 wages and so on i mean this stuff is really confusing right i certainly understand as i've had to make these same decisions for myself and my own company which later went on to become an inc 5000 fastest growing company and i also had the luxury of studying this as a licensed cpa so today i'm happy to give you both sides of the stick the business reasons to determine how to pay yourself and the tax implications you need to consider so you can avoid those painful irs audits i'm going to show you how i pay myself in my own business and the important things for you to consider by the end of this video i promise you you will be equipped with the fundamentals to start paying yourself correctly for your business so buckle up and let's get to the money hi my name is sherman with life accounting a full service accounting firm that is dedicated to helping small businesses grow if you're new to our channel be sure to subscribe so you don't miss out on future videos to help you grow and manage your business and please smash that like button for me to help us reach more small businesses and if you take away any gems from this video today i'm going to tell you the business and tax considerations around how to pay yourself and your business i'm going to break down things like owner draw versus salary compensation and tailor this conversation to your exact entity type so let's begin let's start with the business question how much should you pay yourself a lot of business owners make a huge mistake by paying themselves too early and as a result they suffer severe consequences first and foremost cash is the lifeline of your business it's the blood and heartbeat of your business and if you starve your business of it you will die i really wish i was being dramatic right now but i'm not 90 of businesses fail because they run out of cash period in too many times business owners take so much cash out of their business that they don't even leave enough to pay their expenses like seriously i've seen business owners pay themselves so much that they didn't even have enough money to pay their own employees that aside when you take too much cash out of your business you're also draining your business potential for example amazon which is now one of the biggest businesses in the world was technically unprofitable for the first 14 years of their existence and it wasn't due to poor budgeting or expense management they were consciously reinvesting into their business as a result they grew exponentially faster than anyone could have imagined they revolutionized their industry and now they're one of the largest companies in the world jeff bezos could have easily been greedy in his early years but he wasn't and now greedy people envy his success isn't that crazy anyway my point here is that before you take a dime out of your business you need to first make sure that your expenses will be covered and that you're not starving yourself of your strategic goals that require money to grow your business now that that's out of the way this is how my partners and i pay ourselves in our own business and what we recommend for other businesses first and foremost you should have at least three months of operating expenses in cash this will provide you the security and peace of mind that your business can stomach any unexpected losses can stay afloat so if you lose your biggest customer or the economy suddenly crashes you can weather that storm with your cash reserve secondly you should set money aside to set your strategic business goals that may be more marketing new products buying new technology or simply investing in your existing products and services to increase your customer satisfaction whatever it is set the dollar amount that you will invest in it and leave that in your bank account in cash finally you can pay yourself all that is left in your business after you do those two things any excess cash can be paid to you in a distribution or divided amongst your partners according to their respective equity in your business okay so now that you know how much to pay yourself let's discuss the methods to pay yourself like how much should be paid in salary or in distribution or draws let me start by defining this stuff so you know exactly what i'm saying and what's going on the characterization of your pay is very important for tax purposes which we'll jump into in just a minute here okay so first what is a salary salary is w2 income specifically wages that are subject to federal taxes state taxes medicare social security and so on now what is a draw a draw is simply money that you withdraw from your business think of a bank transfer from your business bank account to your personal business bank account you're receiving this money and is not being taxed at that time so then what is a distribution a distribution is basically the same thing as a draw a draw is a type of owner distribution which is distributing money from your business to yourself however there are different types of distribution like dividends dividends are how shareholders of corporations distribute their profits to shareholders dividends are the ways big corporations pay their shareholders and aren't really used for small businesses typically so go ahead and throw that to the side for the sake of this conversation the real question we're trying to answer here is how much should you be paid in owner draws versus w-2 wages now that the definitions are out of the way let's jump right into it the answer to this question ultimately depends on your entity structure for example sole proprietors partnerships and llcs are taxed on all of their profit regardless of whether that cash is distributed to you or not with this in mind there is no tax reason to pay yourself a monthly salary you're going to get tax on all your profits anyway so it's better to pay yourself something so you can pay your tax bill right tax aside there are legitimate business reasons to pay yourself a salary for one you should always budget a salary to replace you in the event that you are no longer working in the company what if you want to hire a ceo to run the company without you or what if something tragic happens to you and you can no longer work if your business is not profitable in a scenario where you cannot work in the company then that is a severe business risk for example let's say you have a 15 profit margin in your business but that does not include your compensation which you equate to be i don't know let's say 150 000 now if you budget an extra 150 000 in salary to your company and the salary of all of your partners you're probably not going to be profitable in that scenario depending on your revenue and when it's time to sell your business or hire executives and higher level managers you may find yourself stretched for cash because you did not build your own salary into your prices so what can you do to prepare for this you can start by paying yourself a reasonable salary or market-based salary for the work that you do in your business or you may decide not to pay yourself but to add on a little bit more to your profit margin so that you can afford it maybe you'll increase your net profit margin from 15 to 30 percent so you can build more room for that executive compensation it's all your choice but you need to decide and you need to be prepared for things like this in order to scale your business okay then you might be wondering when does it ever make sense to pay yourself a w-2 salary paying yourself a w-2 salary makes sense if your business is a corporation especially for s-corporations you must pay yourself a salary for the services you perform for your company this is because distributions to owners and corporations are only subject to federal and state tax not medicare or social security taxes whereas in llcs or partnerships the government does kind of collect medicare and social security taxes hypothetically through the self-employment tax as you can see here your entity structure largely determines your overall tax liability and if you need help navigating this then we'd be happy to help you craft a tax plan but that aside in corporations a good rule of thumb is to pay yourself a salary for the work you do and get paid distributions based off of the profit you own as long as you do this you can stay out of trouble with the irs okay now let's wrap this episode up with a summary and some action items for you today we talked about how much to pay yourself in your business in short you should have three months of operating expenses and money set aside to hit your strategic goals then you can pay yourself everything that's left you'll need to carefully track your expenses on a monthly basis and craft a budget in order to do this then we talked about the best way to pay yourself for pass-through entities like llcs and partnerships it's normally best to pay yourself through an owner's draw for corporations especially as are required by law to pay yourself a reasonable salary a w-2 salary for the work you perform for your organization if you do not you be evading certain taxes like medicare social security or self-employment taxes that other entities face and could be penalized as a result if you got any value from this video at all please help me out by liking this video and be sure to subscribe to our channel so you don't miss out on future action-packed videos to help you grow and manage your business thank you and i'll talk to you soon you