Can You Afford to Pay Yourself as a Startup Founder?
The first thing startup founders need to consider is whether you can afford to pay yourself at your startup’s current stage.
If you are bootstrapping your startup, using your own money (savings or personal loans) to fund the earliest days of your company, you should have a pretty good idea whether you can pay yourself a salary and how much you can afford to pay yourself.
If you are a little further along and are raising early rounds of investments, you may be able to afford to pay yourself a salary but will need to consider your cash flow and burn rate to determine just when and how much to pay yourself.
The truth is most startup founders do not start paying themselves until they have raised significant capital from angel investors and VCs. Every single dollar you take out of your startup to pay yourself is one less dollar that you have to launch and grow your new venture. Until you have raised significant amounts of capital, many startup founders simply cannot afford to pay themselves.
How Do Entrepreneurs Pay Themselves?
The next thing you will need to figure out is how to pay yourself. There are three main ways that founders can be paid by their startups:
- Owner’s draw
- Dividends and capital gains distributions.
Each of these have their own legal and tax implications for both the startup and its founders. However, how you are permitted to pay yourself is primarily determined by your startup's legal and tax structure.
Owner’s Draw vs. Salary vs. Dividends and Capital Gains
Rather than paying themselves a salary, many small business owners pay themselves with an owner’s draw. An owner's draw is when an owner withdraws cash from the business for their personal use.
Entrepreneurs who pay themselves with an owner’s draw can “pay” themselves (take money out of the business) as they see fit. Owners' drawings can be taken when needed or can be planned on a regular basis. This provides a great amount of flexibility in when and how much business owners pay themselves.
Owner’s draw is primarily used by the owners of pass-through tax entities (i.e. sole proprietorships, partnerships, and many LLCs). In these business structures, the business’s profits pass through to the business’s owners, whether they are withdrawn from the company or not. For a business owner, these earnings are treated as self-employment income, and they are responsible for paying income taxes and self-employment taxes on their business profits.
Many startup founders pay themselves a salary. Salaries are fixed, regular compensation for the work one does for the company — the same way that they pay wages or salary to any other employee of the startup.
A company’s founders or owners determine a set wage for their roles, set aside the appropriate taxes, and cut themselves a check. While the startup’s founders are responsible for paying taxes on their earnings, the startup must also pay their share of payroll taxes, and withhold FICA (i.e., Social Security and Medicare taxes) and income taxes from the founder’s paycheck.
Since a founder’s salary cannot be deducted as a business expense in a sole proprietorship, partnership, or LLC, most founders do not pay themself in the form of a salary until they incorporate their startup or, for LLCs, elect to be taxed as a C corporation or an S corporation.
Dividends and Capital Gain Distributions
In addition to a salary, startup founders, as owners and investors in their startups, can also pay themselves through dividends and distributions of the profits of the company. Dividends and distributions are simply a payout of cash to the owners of a company (shareholders or shareholders of a specific class of stock.)
The company’s owners or board of directors can determine dividends and distributions at any time, approve the dividend or distribution, and cut themselves a check. This can be a huge tax benefit as dividends and distributions receive favorable tax treatment compared to salaries and self-employment income, potentially saving a company’s owners thousands of dollars.
There are certain rules and regulations surrounding the payment of dividends and distributions. Because sole proprietorships, partnerships, and LLCs have to claim all of the profits as self-employment income, they can not pay themselves dividends. For corporations and LLCs that elect to be taxed as C corps or S corps, owners who are employees of the company must pay themselves a reasonable salary, and in the ratio of compensation to the companies, owners’ dividends must not exceed 40%.
Paying Yourself by Business Structure
One of the biggest determinants in how you pay yourself is your startup’s legal and tax structure. The rules and regulations regarding taxation and reporting vary greatly from informal business structures to LLCs and corporations. Let’s take a look at the five most common business structures and how they influence your ability to pay yourself as a startup founder:
Many businesses start as sole proprietorships — individually owned businesses that have not been incorporated or registered as an LLC. The owners of sole proprietorships are “paid” by taking a draw on the profits of the business.
Sole proprietors do not pay themselves a salary and cannot deduct their own salary as a business expense. Rather, in sole proprietorships, business profits are passed through to the business owner, and the owner must pay income and self-employment taxes on all of the profits of the business, whether they are withdrawn from the business or not.
Sole proprietors then pay themselves by taking a draw on the profits. Since they are the sole owners of the business and are responsible for all of the taxes on the profits of their business, they are free to take a draw on the profits at any time. This type of taxation is known as pass-through taxation because the business’s earnings, losses, expenses, and credits pass through the company to the owner and are reported on their personal tax return.
One major disadvantage of pass-through taxation is that the business’s owners are responsible for paying both income tax and self-employment tax on all of the business’s profits, whether those profits are paid out or retained by the business.
For example, if a sole proprietor earns $75,000 in profits, assuming an effective tax rate of 20%, they would be responsible for paying $15,000 in income tax and $11,475 of self-employment tax on these profits for a whopping total of $26,475 in taxes, whether they withdraw any of the profits from the business or not.
Sole Proprietors are responsible for Income Tax and Self-Employment Tax on their entire business profit.
In partnerships (businesses with multiple owners that have not been incorporated or registered as an LLC) partners are “paid” the same as sole proprietors: with the profits of the business.
Partnerships do not pay partners a salary and cannot deduct any partner salaries as a business expense. Like sole proprietorships, partnership profits are passed through to the business owners, and the partners must pay self-employment and income taxes on their share of the business’s profits.
Partners are also free to take draws on their shares of the profits as they see fit; however, a partner’s draws are often laid out in a founders’ agreement or partnership agreement.
For example, if two founders in a partnership earned $150,000 and the partners agreed to split the profits equally, each partner would be responsible to pay income and self-employment taxes on $75,000 — their share of the profits. For each partner, this would look identical to the scenario for sole proprietors above.
Like sole proprietors, Partners are responsible for Income Tax and Self-Employment Tax on their entire partner’s draw.
In a limited liability company (LLC), the owners (known as members) of the LLC may have several options for determining how they are paid by their startup. This provides LLCs with some flexibility in how entrepreneurs pay themselves and how profits are taxed.
By default, LLCs are treated as pass-through tax entities and require a little more paperwork than sole proprietorships or partnerships.
Similarly to sole proprietorships and partnerships, each member's share of the profits are passed through according to their ownership, and each member must pay self-employment and income taxes on their share of the business’s profits. The table below shows an example of pass-through income for an LLC member.
LLCs also have the option of electing a C corporation or S corporation tax status. If an LLC elects to be taxed as a C corporation or an S corporation, then the startup’s founders may pay themselves a salary, deduct their salaries as a business expenses, and pay tax on any additional profits according to the laws and regulations governing C corporations or S corporations. We go into this in more detail in the sections below.
Keep in mind that LLCs need to elect to be taxed as a C corporation or an S corporation and file the proper paperwork with their state and the IRS.
Recommended: Read our guide on how to pay yourself from an LLC for more on how to pay yourself as an LLC or S corporation.
By default LLCs are pass-through entities, so members of LLCs would be taxed the same as sole proprietorships and partnerships unless the LLC elects to be taxed as a C-Corp or an S-Corp.
In a C corporation, the founders of the corporation can be “paid” in several ways. Founders who work in the corporation can pay themselves a salary, just like any other employee in the organization. In addition to a salary, corporations can also pay any excess profits to the owners (shareholders) of the corporation as dividends.
If you are operating a C corporation, paying yourself dividends creates several tax advantages. Not only are dividends currently taxed at a lower, preferential tax rate, but they are also not subject to employment taxes (FICA taxes) that would be withheld from your paycheck.
In general, the founders of a corporation do not have to pay themselves a salary; however, in some states such as California, if the owners of the corporation are working in the corporation in any form then they must pay themselves at least the minimum wage.
You may be thinking that you should just pay the minimum amount in salary and the rest in dividends, but there are specific guidelines from the IRS that must be followed for C corp founders who do compensate themselves through dividends. The general requirement from the IRS is to follow the 60/40 rule, which states at least 60% of your compensation should be in the form of salary and up to 40% can be paid as dividends.
Looking at the same scenarios as above, the founder of a C corporation that makes $75,000 in profits could pay themself a $42,250 salary. The corporation would deduct the salary and their share of the payroll taxes as a business expense and would pay corporate income tax on the remaining profits (15% of $29,518 of corporate profit). The remaining profit could then be paid as a dividend or distribution.
In this situation, the founder would pay FICA and income taxes on their salary and capital gains taxes on the $25,090 distribution from the company's profit. Under current tax law, in many cases, founders with no other income would be subject to a capital gains tax rate of 0%. For this case, this would result in an overall tax decrease for a single owner founder, making the same amount of profit as a sole proprietorship, providing personal tax savings.
In corporations, owners must pay themselves a reasonable salary but may withdraw distributions of excess profits at more favorable tax rates.
An S corp is not a business structure; it is an IRS tax classification. Both LLCs and corporations can elect to be taxed as S corporations.
S corporations are a hybrid pass-through tax structure where an LLC or corporation's income or losses are passed through to its shareholders for tax purposes. Similar to C corporations, compensation to an S corp’s owners is divided and taxed in two parts — salary and distributions.
S corporations have a special set of rules they must comply with when it comes to the owner’s compensation. First, owners of an S corporation that also manage or are employees of the organization must pay themselves a reasonable salary through the LLC or corporation. According to the IRS, reasonable compensation is defined as the “amount that would ordinarily be paid for like services by like organizations in like circumstances.”
After receiving a salary, any profits of an S corporation over and above the owners’ salary are treated as a distribution rather than as self-employment. Thus, owners and shareholders pay tax on the capital gains that are passed through to them but do not pay self-employment tax on the distribution portion of the proceeds.
Looking at the same scenarios as above, the founder of an S corporation that makes $75,000 in profits and pays themself a $60,000 salary will pay income tax, Social Security, and Medicare taxes on the $60,000 salary and will pay capital gains taxes on the $15,000 that passes through as a distribution.
The owners of S-Corporations must also pay themselves a reasonable salary. Excess profits are distributed as capital gains distributions at more favorable tax rates.
Which structure is right for my startup? The best structure for you to pay yourself as an owner depends on your business’s needs as a whole. For a bigger look at business and tax structure benefits, check out our How to Choose a Business Structure guide.
How Much to Pay Yourself as a Startup Founder
When you can afford to pay yourself and you have determined how to pay yourself, the final question is how much to pay yourself as a startup founder.
There are a number of factors that figure into how much you should pay yourself as a startup founder including your business’s structure, performance, profits, stage of growth, and whether you have taken on significant investment.
Many early-stage startup founders don’t pay themselves anything at all. Since every dollar taken out of the business is one less dollar to use to build and grow the business, most startup founders do not start taking any salary until they raise a seed round of funding. Before this, most are working for equity.
But, startup founders have bills too. Many startup founders begin to pay themselves once a startup receives seed funding (their first significant investment).
As a startup founder, your roles as an owner and investor are not the same as your role as an executive and employee of the company. As an owner and investor, your equity in the business grows as you grow the business. As an executive and employee, your salary should reflect the value of the work that you do.
If your business elects to be taxed as a C corporation or an S corporation, this is especially important. You will be required to pay yourself a reasonable salary and will need to figure out what this is.
Average Entrepreneur’s Pay
If you are wondering what the average startup founder pays themself, it highly depends on the startup’s location, stage of growth, and whether you have taken on significant investment.
As you know, most startup founders don’t pay themselves anything at all until they have received a significant seed investment, and many don’t pay themselves until they have raised even more angel and venture capital.
In a typical startup that receives seed funding, startup founders often begin paying themselves salaries ranging from $50,000 to $60,000. Startup founders have bills to pay too.
Once a startup continues to grow, gain traction, and generate revenue, startup founders’ salaries grow as well. Startup founders who lead their ventures through Series A funding often increase their pay from its initial level, sometimes doubling their salaries to the $100,000 range.
In order for startups to grow and thrive, founders will often raise their salaries accordingly, with startup founders that are close to leading their companies toward a merger, acquisition, or IPO paying themselves upward of $250,000 or more.
According to Zippia, the average entrepreneur’s salary is $74,224 per year, or about $35.68 per hour (based on a 40-hour workweek), but this can vary widely. Entrepreneurs in the bottom 10% of salaries reported an average salary of $41,000, while those in the top 10% reported average salaries of $134,000. However, as many of these salaries are based on non-founder roles, it is difficult to determine exactly what qualifies as an entrepreneur.
The bottom line is when you are in the growth phase, most startup founders pay themselves little to nothing — only as much as they need to survive. As startups take on investment, grow, and flourish, founders begin paying themselves a reasonable salary and raise it in line with the company’s continued success.