Our Small Business 101 series is for anyone who owns a small business and for anyone who's thinking about starting a small business. It draws from lessons we've learned while working with thousands of Canadian small business entrepreneurs over the years. It's the class we wish we'd taken before starting Origami. And the night class you should be taking right now.
“How much should I pay myself from my business?” This is a question our CPAs get asked a lot. Another one they get asked — very related to the first — is “How’s my business doing?”
Our clients — small business owners across Canada — have a sense of where they stand on both fronts, but they don’t always have a point of reference. So they want to hear from their Origami CPA. Our CPAs work with clients across industries and markets and can draw from a wider perspective when thinking through their answers.
While their answers inevitably depend on the individual situation, there are a few general principles at play. I want to cover those principles quickly in this post.
Regardless of the business, Goal #1 is to pay yourself a market rate salary for the work you do in your business.
Because if you can’t do that, if you can’t pay yourself the going rate for the role you play in your business, what’s the point? We’re not talking about paying yourself what you’re worth but about paying yourself what your position is worth. A neurosurgeon managing a retail boutique should aim for a well-paid boutique manager salary, not a neurosurgeon salary.
There are good reasons for this:
- When you’re starting out, you’re likely not going to be able to pay the market rate. But having this as a concrete goal helps focus your efforts. It becomes a roadside marker to steer toward and, eventually, a milestone to celebrate. Concrete goals matter.
- Once you’re paying yourself a market rate for the work you’re doing in your business, you can think about hiring someone else to do what you do, allowing you to spend more time working on your business rather than in your business. This is moving up a level in the game of business.
- The Income Statement is meaningful now. If you have a loss because you’re paying yourself a market salary, you know very clearly you need to increase your sales. But if your company has a positive net income because you’re not paying yourself a market wage, then you know you’re not quite there either. It’s another level of thinking.
There are nuances here. You may be holding down multiple jobs in your business. You may be working longer hours than an employee would or could. Your business may be a side hustle. But these, among others, tend to be edge cases. The general principle of paying yourself at market rate holds for most small business owners.
You should prefer salary over dividends.
We wrote a post about salary vs. dividends (How to Pay Yourself in a Small Business) where we didn’t come out and take sides. Here, we’re taking a side.
Here’s Kris Sparrow, one of our Origami CPAs, on the topic:
“From a tax perspective, paying yourself a salary is pretty much on par with a dividend, as far as taxes owed. And, unless you believe the CPP is going to collapse (and you shouldn’t; here’s a recent Government of Canada news release on the program), a salary has a favorable tax treatment and is unambiguously better for most situations.
“A big positive is that when you pay yourself a salary, you pay your taxes as you go, as opposed to taking money as you need it and then having to come up with money for the surprise tax bill at the end of the year. A salary makes it easier to budget, because the taxes are already taken into account. In addition to that, a salary gives owners a more accurate view of how their business is doing.”
Dividends are supposed to be a means for companies to return their profits to shareholders. But what we often see in the small business context is that dividends are a kind of make believe. Most owners who choose this route take what they need personally directly from the business bank account. This gets treated as loans from the business to the owner throughout the year that have to be "repaid" by the paper transaction of declaring a dividend. This is needlessly confusing, distorts the company’s monthly financial statements and, for the owner, it often means coming up with a large sum of money to cover a tax bill at the end of the year. An unpleasant outcome — and an avoidable one if you instead go with salary.
Pay yourself dividends when your business can afford to pay dividends.
Let’s hear from Kris again:
“Even when your business is doing well, we advise leaving two to three months of operating expenses as a margin of safety in the business to cover fluctuations in sales and other weird disruptions. Anything over and above that two to three months, we encourage you to take it out.
“You should either take it out as a dividend to yourself for your personal consumption or as a dividend to a holding company that you’ll use to invest in other businesses — if you want to do that. But it should come out of the operating company. It shouldn’t just sit there. Unless you’re saving for a big expansion or something, then sure.
“But, if you have an operating company, and you’re at where you want to be as far as reinvestment in the business goes — which would be true for most businesses that have limited scope to expand — then these excess earnings should either go to your RRSP, to a TFSA, or to a holding company if you’re going to buy other businesses or pursue other ventures.
“But it should come out. If equity is high enough to cover two to three months of operating expenses, then, by our simple rule, the excess of that should come out of the business.”
Small business owners should have different expectations for the compensation they can take from their business as their business evolves.
One assumption entrepreneurs make when starting a small business is that their business will (eventually) return their investment of time, money, and effort. Initially, they may aim for a level of compensation that just pays their bills, preferring to leave most of what’s coming in to support the business. Then, when the numbers look healthy, they’re looking for an income level that supports a lifestyle and eventual retirement. Eventually, if they’ve managed to build their business into a money making machine, they want to think about their larger financial goals and potentially diversify into other projects.
This is the plan. But the plan usually takes time to come together. It unfolds in stages. And, if we’re being honest, most plans don’t reach the later stages.
We discussed this at length with Kris here: How to Pay Yourself at Different Stages of Your Small Business
Your compensation, as the owner, is tightly coupled to the financial performance of your business. And a small business, especially a new one, needs time to find its feet.
There are two things to avoid: taking too much money for yourself too soon, and taking too little money for yourself for too long. The first puts pressure on your business because there won’t be as much money to support operations and growth. The second puts pressure on you and your family because you’re propping up a business that just may not work.
It’s sometimes hard to spot these patterns from the inside and to have a sense of what stage your own business is at. This is where the experience and judgment of a CPA prove valuable. Your CPA should be able to read the financial signals and tell it like it is, so that your personal compensation stays aligned to the business results. This also means pointing out the opportunity cost and hit to your future financial security of “hanging in there” a little too long.