As a small business owner one of your biggest concerns is likely how to pay yourself. Being well-compensated is a big part of feeling valued, confident and productive.
Now, think back to the first paycheck you ever received.
If your experience was anything like mine you were probably in your late teens or early twenties, and earning $400 in two weeks seemed like a million bucks.
You were thrilled with yourself for working so hard and earning some good money. You even rewarded yourself with a jacket to go with your new cubicle, or messenger bag to carry work-related files into your new job.
(No? That was just me? Okay…)
Fast forward to your career now and you’re the boss. You work for yourself whether it’s writing, editing, designing, or photography, and the money you earn every month just doesn’t come with the same sense of pride or accomplishment.
Because working with clients or companies as a freelance contractor can often suck the life and joy out of your work.
You’re usually paid late, if you’re paid at all. And then comes the admin; the constant need to categorize your income, keep track of your expenses and bill out invoices to clients.
What happened to all that money? How can you get that feeling of pride back in your work?
Here’s how to stop the vicious cycle of being bitter towards your finances and start loving them again!
Treat yourself like an employee
If you’ve been reading this blog for awhile you’re probably wondering why the heck I’m saying to think of yourself an employee, when I always advocate to be the boss in these situations.
But hear me out.
When it comes to loving your freelance finances, you have to view yourself as a vital part of what keeps your business going (often the most important part). In other words, you have prioritize paying yourself just like you would an actual employee who worked for you.
If you hired employees, you’d pay them on time, right?
Maybe even offer them benefits like health insurance, and retirement contributions. Even if that meant taking money out of savings, or taking on extra clients to cover payroll.
Soooo why don’t you prioritize your own “salary” as such?
Don’t worry, I too came to this realization and had to change my own mindset about paying myself.
As freelance business owners we put our financial needs at the bottom of the pile, and then wonder why the heck we don’t feel properly compensated for our work. One way to change this is by taking yourself seriously, just as if you were an employee at your own company.
Decide on the best payment method
Now that you’re on board with compensating yourself properly, what’s the best way to go about it? There are several payment methods for self-employed business owners.
Simply choose the best one for the structure of your business.
A bank-to-bank transfer from a personal checking account to a business-designated bank account is the simplest form of paying yourself a “salary”. In the eyes of the IRS your money is classified the same if you’re a freelancer functioning as a sole-proprietor.
Basically all the income you make is yours and there’s no legal need for separation.
But for the purposes of proper bookkeeping and admin, it’s a good idea to set up separate bank accounts; one for personal bills and household expenses and another for business-related income and expenses.
In this case you’re free to withdraw money whenever you’d like. A simple transfer, check or direct deposit is best for freelancers and sole-proprietors.
As you register for an LLC, or enter into partnership ventures, how you pay yourself as a business owner becomes a bit more complicated.
Instead of a simple bank transfer, you’ll take what’s known as an Owner’s Draw and classify these as such in your bookkeeping software.
These withdrawals consist of cash, or other assets, that the business owners takes out of the business for personal use — such as household bills, entertainment funds and the like.
This includes purchases you make with the business credit card or debit card. The draw of cash will be recorded with a credit to the Cash account and a debit to the Owner’s Draw account (which is an equity account).
Basically you’re paying yourself (as the boss), and making a check or direct deposit transfer, to yourself (as the personal employee). I know that sounds a bit confusing, but just think of it as one person wearing two different hats.
The Boss Hat makes the checks from the business bank account, and the Employee Hat deposits the checks into their personal bank account.
Then you record this transaction in your bookkeeping to keep everything straight. Okay, maybe that’s three hats since you’re also the bookkeeper. Ha!
The Owner’s Draw method is best for LLCs (including single-member LLCs) and partnerships. Although, this method does also apply to freelancers who are sole-proprietors if you want to have proper bookkeeping.
If your business is set up as a corporation, or S-Corp, you’re required to be paid a regular salary from the business bank account. This is different than an Owner’s Draw, which has little affect on your personal income taxes and is most for bookkeeping purposes.
As a corporation, though, your business will have it’s own tax return and you must show “reasonable compensation” for your salary. A traditional salary is best for S-Corps and other corporation type businesses.
Obviously, these methods can be a bit confusing so it’s a good idea to chat with a CPA or bookkeeper who understands your freelance business and can share their professional opinion on what the best choice is.
What do I use? I simply take an Owner’s Draw and transfer funds from my business-designated account to my household checking account.
Calculate the exact formula
No matter what kind of payment method you choose to pay yourself, the IRS requires that you be paid “Reasonable Compensation” for your efforts. Yep, even the government wants you to be properly rewarded for your hard work.
This clause keeps freelance business owners from under or over-reporting their personal income, or under or overpaying themselves based on the business’ profit margin.
Over the years owners of S-Corps have come under much more scrutiny from the IRS because they don’t pay themselves a proper salary.
Because of this, one of the largest financial risks that entrepreneurs incur relates to penalties and interest for incorrect payroll tax reporting. So keep that in mind when you’re thinking of not paying yourself the proper amount. The IRS may require you to do so!
How do you calculate the proper amount for getting paid? What’s the exact formula for paying yourself as a freelance business owner?
THE EXACT FORMULA
Profit (or loss) = total revenue – business expenses
Taxes = 25-30% of profit
Your paycheck = 70-75% of profit
The exact percentages should be tweaked to your personal situation, but these figures are usually the baseline.
In my case, I like to reinvest money back into my business, for courses, advertising, outsourcing, etc. So my personal business profit formula looks like this.
CALCULATE BUSINESS PROFIT
Profit (or loss) = total revenue – business expenses
Taxes = 30% of profit
Reinvest back into business = 10% of profit
My paycheck = 60% of profit
Since being self-employed for over three years, I’ve found that dedicating 30% to taxes is about how much I end up paying including federal, state and self-employment taxes.
But your exact figure may be lower or higher depending on what state you live in.
CAREFUL CENTS PROFIT & PAYCHECK
$6,500 (monthly profit) = $8,000 (total revenue) – $1,500 (business expenses)
$1,950 (taxes) = $6,500 x 0.30 (30% of profit)
$650 (reinvestment) = $6,500 x 0.10 (10% of profit)
$3,900 (my paycheck) = $6,500 x 0.60 (60% of profit)
$8,000 – $1,500 – $1,950 – $650 = $3,900 (net)
The above example is a reflection of the actual numbers and formula I use to calculate my own “salary” from Careful Cents. This means I pay myself around $4,000 a month to cover household expenses and other personal needs.
Choose how often to pay yourself
Woohoo! Now it’s time to actually get paid cash money. The only obstacle left is to figure out exactly how often to pay yourself.
Again, the right answer will depend on your business set up and your personal needs, but there are some basic solutions for everyone.
- Semi-monthly (twice-a-month)
- Biweekly (every other week)
In the past I’ve paid myself both monthly and weekly, the latter being the best fit for my freelance schedule. I have an automatic transfer from my business checking to go to my personal checking account every Friday, with the occasional one-off transfer when necessary.
Obviously, nearly everyone wants to be paid on a more frequent basis.
But you also have to take into account the additional admin such as, making transfers back and forth between accounts, recording these transactions in your bookkeeping software and following up with client payments more often.
All of the admin take more time and thus comes with a higher price tag. Especially if you outsource your bookkeeping to an assistant, CPA or payroll firm.
A study from Gusto.com breaks down the most popular, and cost effective, payment schedules for how often business owners and employees get paid.
Start loving your business finances again
There are multiple facets that go into calculating how much to pay yourself as a freelance business owner, but the good news is that you can custom each choice to fit your preferences.
If you find that you need to set aside more money for taxes, or want to pay yourself more frequently, you can change things up until you find the perfect balance.
Just keep in mind how important it is for you to compensate yourself properly, so you can feel worth in your work again.
Nobody likes doing work for free, and you’ll continue to grow bitter and hateful towards your finances if you don’t reward yourself with the money you deserve.