Setting your salary

Starting a business can be quite a roller coaster ride of adventure. You know, the kind of adventure that includes dreams, sweat...and sometimes, tears. But one question that can bring the ride to a screeching halt is, “How much should I pay myself?”

Figuring out reasonable compensation isn’t just finding the balance between your personal needs and the financial health of your business. It’s also important for keeping the IRS happy.

Reasonable compensation defined

The IRS defines reasonable compensation as “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” Basically, you need to do your research to ensure you’re paying yourself the same as other similar businesses. If the IRS comes knocking, the onus is on you to ensure your compensation is reasonable.

If your business qualifies as an S corporation, reasonable compensation works a little differently. The IRS says, “S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.”

You can potentially save on employment taxes if owners take a lower salary and receive the remainder of their income as dividends. However, if the IRS deems your salary as reasonably low compared to the services you provide, they could reclassify your dividends as salary. And that means you could end up paying more in back taxes, penalties and interest.

How to determine reasonable compensation

To make sure your paychecks are in line with IRS guidelines, you have to consider several factors that the IRS outlines. These will help you determine what counts as reasonable compensation and can include:

Your role and responsibilities

Are you the CEO overseeing everything, or do you have a more specific role? The more complex your responsibilities, the higher your compensation should reasonably be.

Your time and effort

Consider the number of hours you work, the types of tasks you take on and your level of dedication. Your compensation should reflect a reasonable reward for the time and effort you put into your business.

Your experience and qualifications

Take your skills and industry experience into consideration. Your knowledge, skills and qualifications provide value to your business.

The nature of your business

Your industry and market play heavily into reasonable compensation. Generally, a tech startup owner earns more than small retail shop owners due to the nature and complexity of the business.

Comparisons with salaries paid in similar companies

Research websites like Glassdoor, Indeed or PayScale to investigate what similar businesses in your area or industry pay for comparable roles. While it’s important to pay yourself a reasonable wage, you don’t want to overburden your business financially. Consider temporarily taking a lesser salary when starting out or going through a rough patch.

Seek professional advice

As a small business owner, determining what salary to take and leaving profits for your business can be a balancing act. And with the complexities of IRS tax laws, it can seem daunting. Before the IRS comes knocking, spend some time with your tax professional or accountant to help guide you to a reasonable—and IRS-approved—compensation.

Back to issue