Use these 2 principles to pay yourself responsibly
Can you feel that? The sun’s shining a little bit brighter, the air is fresher than usual. Is it spring? Nope, it’s payday!
If you’re here, you might fall into one of two camps:
- You’ve just started your business journey and you want to make sure you are paying yourself the right way before your business actually starts making revenue ($$$)
- Your business is already bringing in revenue and you’ve been paying yourself without any real system (or you’re using your business as a bank account), and maybe you’re afraid you’ve made a mistake by doing so
In either case, I’m glad you’re here. It means you’re on the right track to paying yourself legally and responsibly, so don’t worry! But before you dive into that spring shoe sale, let’s dial it back and make sure you’re spending money that’s actually yours. Read below to find out the 2 simple things you need to remember to make sure you’re paying yourself the right way.
1. Your Business’s Money Is Not Your Money!
If you only remember one thing from this blog post, let it be this: your business’s money ≠ your money!
Your business’s money can be broken down into two buckets: revenue and profit.
Revenue is the total amount of money your business brings in.
Profit is your business’s revenue less expenses (like operating costs, which can include marketing, office supplies, software costs, and more).
Profit can be broken down even further into gross profit and net profit. You’re probably already familiar with this if you’ve ever received a paycheck before. Gross profit is your business’s revenue less expenses, and net profit is gross profit less taxes.
If you’re someone who falls into the second camp we talked about before (your business is already bringing in revenue and you’ve been paying yourself without any real system), you may have found that after paying your expenses, like freelancers, marketing costs, office supplies… you’re not left with much at all, and you’re living paycheck to paycheck. Or perhaps you’re paying your personal expenses from your business revenue without allocating the money to properly pay your expenses and taxes. Either way, you could be getting yourself into real financial trouble.
It’s important to remember that your business’s money is not your money—you need to allocate a certain amount of revenue to expenses (money it takes to run your business) and profit (compensation, or the money that goes in your pocket for personal expenses). If you have an organized system that you use to allocate these funds, you can be sure you’re being responsible with your business’s money and preventing financial (and even legal) problems down the road.
Whichever system you use (it doesn’t matter!), just make sure that you…
2. Pick a System and Stick to It!
The method in which you choose to pay yourself (written check, ACH transfer, cash) doesn’t matter. As long as it is consistent (you apply it the same way every time payday rolls around), you’re probably paying yourself responsibly.
One of the best pieces of advice I’ve ever received is to put profit first (a method put forward by Mike Michalowicz, author of Profit First). What that means is that you pay yourself first before all of your business’s money gets eaten up by expenses. We touched on this a little bit earlier—if you’re not using a dedicated system, you might be letting all of your revenue go to expenses instead of putting your profit first.
If you’re finding that you’re living paycheck to paycheck, try the profit first method. Michalowicz proposes that we use this formula: sales - profit = expenses.
For example, if your business’s annual revenue is $250,000, your profit first breakdown might look like this:
That means you only have $87,500 to spend on expenses each year. It’s easier to limit your expenses because you have a cap on it that’s different from your overall revenue.
This ensures that you’re:
- compensating yourself fairly
- putting money aside for a rainy day (and in business, it’s been known to rain!)
- making sure your expenses don’t eat up all of your profit
- not accidentally stealing from the government (that’s what it means when you don’t have enough money to pay your taxes!)
The best way to start the profit first method is to set up bank accounts for each bucket:
- Revenue: this is where all of your business’s money comes in
- Profit savings
- Owner’s (your) pay
- Tax savings
- Operating expenses
You should then distribute your revenue twice per month from the main revenue account to the other accounts. This is the automatic way to save for taxes, pay yourself fairly, and limit your expenses.
However you choose to distribute that money to these other accounts is a matter of personal preference (whether it be by check, direct deposit, ACH transfer, Venmo, or another method) and is not important. The single most important thing is to pick a system and apply it consistently!
It may take a few months of trial and error to figure out what allocations (%) for each category work best for you and your business, but as long as you’re consistently allocating your money, you’re going to be just fine!
Bonus: What System Do You Use If You’ve Elected to Be Taxed as an S-Corp?
(Hey! If you’d like a quick recap on S-Corps, what they are, and why you might choose to be taxed as one, check out this blog post!)
If you’ll recall, an S-Corp owner can choose to receive both dividend and salary payments from the business, meaning they are taxed less since dividends are not subject to self-employment tax. Salary payments are also known as employee pay, and dividends are commonly known as distributions.
It’s still a good idea to follow the profit first model, but it’s important to note that the amount you set for employee pay must be a fair amount in the eyes of the IRS. But what’s fair? How much are you supposed to be paying yourself?
Basically, you need to make sure you’re paying yourself what you would hypothetically pay someone else to do your job. This is so that the IRS doesn’t decide that you’ve decided to pay yourself less in order to pay less taxes.
Other than that, the same principles still apply: your business’s money is not your money, and pick a system and stick to it!
Paying yourself responsibly is only one part of legally protecting your money.
If you want to keep more of the money you make, there are a few important steps you can take (I swear I didn’t mean for that to rhyme).
It starts with the way you create your business, run your business, work with clients, and how you plan for the future of your business. The Artful Contracts How to Legally Protect Your Money course will tell you how to protect your money and make sure you keep more of your business’s revenue (and save you from legal troubles in the future).
The course will help you discover 5 areas of your business that have the impact on your revenue and how you can ensure more of it stays with you.
In business, it’s not an issue of if but rather when sticky situations will arise, and the How to Legally Protect Your Money course will prepare you to better navigate them.