Why 87% of Business Owners Pay Themselves Wrong

I would argue if you own a corporation and you're looking to build wealth, let's leave the funds inside your corporation and let's avoid paying tax altogether until you eventually pull those funds out. The more you avoid paying tax up front, the faster those investments are going to grow. If I have $1,000, I'm going to pay approximately 12% in tax. So my $1,000 is now $880. I have $880 versus $500, which one is going to grow faster and accumulate net worth at a faster pace? I've got a breakdown of how this works from your business where it is now to being a millionaire in 4 years. But you have to resist taking that money out now, and that's where it becomes challenging. Good day and welcome to the Wealthy Entrepreneur Podcast. I'm your host, Bob Gauvreau. It is a pleasure to have you here with us today. Listen, I'm going to do a little bit of a training today, and it's going to be focused on how to pay yourself as a business owner. But before I get started, I just want to remind you that the Wealthy Entrepreneur Podcast is the place where you go to dissect the elements that contribute to entrepreneurial success. We focus on mindset all the way through to leadership, to profits and revenue. And once again, I want to talk a little bit about one of the struggles that I see with business owners today, which is how to truly pay themselves. And one of the things I would say is one of the most common challenges that founders and entrepreneurs and business owners face is how to truly compensate themselves properly, because there is a best way and it's not always going to be the same for every single person. So what I'm going to do in the next few minutes here, let's give it 10 to 20 minutes. I'm going to break down how owners should think about salary, uh, dividend distributions, and even some wealth planning tools and tips along the way so that you can bring in income to your household, but that you can also focus on wealth generation along the way. So let's start this off, right? So really, if you are a business owner, there's a few ways to pay yourself from a business. Now I'm going to make a few assumptions here. I'm going to assume for a moment that we're all in a corporation, right? Whether it's a corporation in Canada or it's an LLC, S corp, C corp in the US, it's really the business is a separate legal entity. Uh, in the US it's a flow-through you, which is a little bit different. But in Canada, corporation is a corporation. It's like a C-corp in the United States. So I'm going to make an assumption there. Now I'm going to park that for a minute and say there are other ways, right? If you are a partnership or you're an individual sole proprietor, regardless of how you pay yourself, you're paying tax based on the net income of the business. Okay? As a sole proprietor or a partnership that does not have a corporate partner, You are paying tax based on the available income. Now you can pull all the cash out. So for example, if you're a sole proprietor and you sell a bunch of prepaid gift cards and there's a bunch of cash in the business, you can actually take that out, ultimately not paying tax on it until you've earned that income and you've pulled that money out and it's going to be essentially tax-free. Now, later on, when you earn that income, you're going to have to pay the tax on it, but proprietorships, partnerships, slightly different, right? Again, it's solely based on the income being generated in the business, not on how much you pull out. So let's go back to my assumption of a corporation. Okay. So corporation essentially has revenue and expenses that go in. The business is going to pay tax on the net income of the business. Now, when we think of compensation, there's really two ways that you can pull money out of a corporation. Okay. The first one is a salary. Now the salary is just like you were You're working anywhere else. You're an employee there. You do not have to pay yourself a salary. That's not a requirement. But if you do pay yourself a salary, you're going to be paying taxes at the marginal rate for you personally, all the way up to 55, 56, 57%, um, 50 in the United States, uh, which would be California, depending on the state. So that's marginal tax. It goes from zero and then depending on how much money you make, it goes all the way up to 57%. Now, the good news in using a salary is that the business gets a deduction. So let's say the business had $200,000 in revenue, $100,000 in expenses, your net income is $100,000, but then you pay yourself a salary throughout the year. That $100,000 would be deducted and the business would not pay tax, okay, with that full deduction. Now, the other way that you can pull money out of the corporation is you can pay it as a shareholder. So as an investor in the corporation, if you are an owner of the shares, which typically business owners are, maybe there's some family members that are in there, maybe there's a family trust in there, you can technically pull the funds out and you pay dividend tax on that personally. So the downside is the business doesn't get a deduction, right? So if you, again, $200,000 in revenue, $100,000 in expenses, $100,000 of net income in the business, the business is going to pay tax on that. You're going to give an after-tax distribution to yourself, right, of the money after tax, and you're going to pay personal tax on it. Now, your personal tax rate is significantly lower. So I know we talked about 56, 57%. It's upwards of 43%, right? So typically, if you're matching salary and business total tax rates and dividends and business tax rates, they're going to match in the system. The system is created for it to be that way. Now here's what you need to know. Some differences. If you're paying yourself a salary or you're paying your spouse a salary or your kids a salary who are over 18, depending on where it is that you live in Canada, you're going to be having to pay Canada Pension Plan contributions, not only the employee side, but the employer side, which is upwards of over $7,000 a year. If you're paying yourself a salary of more than $55,000. Per individual, where individuals that work for you, you have to pay half and they have to pay half. In your case, as a business owner, you have to pay both sides. Very, very costly. So that's $7,000 in cash flow that you would be spending throughout the year. That's higher than what you would on a dividend typically. It does though create RRSP room for you personally. So Registered Retirement Savings Plan, if that's something that you want to contribute to, I would argue if you own a corporation, and you are looking to build wealth, let's leave the funds inside your corporation or inside a holding company, and let's avoid paying tax altogether until you eventually pull those funds out. And the reason we do that is the more you avoid paying tax upfront, the faster those investments are going to grow and accumulate your wealth in a really significant way. So here's a good example. Okay. So let's just use salary and let's say the tax is 50%. So if I have, you know, $1,000 of income in my business, I pay $1,000 salary out. The business pays no tax. Okay. But I'm going to pay 50% tax on that. So my $1,000 that I get out is now $500. I invest that $500 and it's going to continue to grow. So let's keep the $500 in mind. If I have $1,000 in income inside the business, but I don't pay the salary, I'm going to pay approximately 12%. In tax. So my $1,000 is now $880. So I invest that $880 inside the corporation in the exact same investment I would have personally, but I have $880 versus $500. Which one is going to grow faster and accumulate net worth at a faster pace? Very clearly the $880. So the idea would be for individuals to leave as much money in as you can, make your personal investments. Let's not make an RRSP contribution. Let's take those personal investments and let's get them working inside the corporation. Now, I'm going to take this a step further just for a moment for all of you who are listening to say, if you've got investments inside your corporation or personally, the type of investment that you have is taxed differently. So not necessarily whether it's personal or in a corporation, but if you have an investment, let's say you buy a stock or an index fund and you buy an index fund for $100. It grows to being worth $200 throughout the year. That is not taxable. If you sell it for $200 and you pocket the cash, that is taxable. So what we want to try and find is whether it's in the corporation or personally, we want to find investments that are going to be as tax-free as possible for as long as possible, and then we'll pay tax at the end. Okay. So that deferral allows for the increased compounding effect of the investments along the way. Ultimately maximizing our wealth accumulation. And then when we pay tax at the end, the type of investment income you have gets taxed differently as well. Capital gains are the most preferred. So if we can hold something that's going to be growth-oriented and we're going to pay tax on it later, the tax rate's going to be lower. If we're going to pay, have an investment now that triggers some type of dividend ongoing, tax rate's going to be higher than capital gains. We're going to be paying tax along the way. We have reduced reinvestment in capital, which means our accumulation of investments over a longer term are going to be less. So thinking about those things when we're investing, uh, I know I've got off the topic of compensation strategies, but I feel like this is valuable. You know, the idea would be finding investments that minimize your tax in the short term, maximize your tax efficiency in the long term, and also maintaining them inside your corporation versus personally. If you stack those together, it's a track record of success and maximizing wealth accumulation there. So a little bit of a sidetrack, but I wanted to make sure that we got that out there as well. So let's go back to paying ourselves. So I talked about the difference between salary and dividends. So let's even take a step further. You know, how much should you be paying yourself? As a business owner, whether it's salary or dividends. So what we want to do is we actually want to start with doing some personal budgeting and identifying just how much money we need for our household, not only to survive, but to enjoy life a little bit. And then we reverse engineer it to say, okay, what is this before tax? How much do I need to take out? How much do I need to pay in tax so that I get that net income amount? Now, it's important that we define this And then once we establish it, so let's say we need $5,000 a month. We likely, if it's a salary, that would probably be $10,000 a month in salary. We pay 50% tax. That will give us our $5,000. The $5,000 pays our bills, lets us eat dinner, go out and enjoy ourselves with some entertainment, pay for our kids' sports, go on vacation, whatever that looks like. We want to understand what that is, right? And it's going to be $10,000 that needs to come out monthly from our business. Okay. What we want to do is we want to get this as small as it can be so that we get to enjoy our life and we want to keep it tight. And the idea would be from a cash flow planning standpoint, we want to take the money out of our company fairly frequently. So let's join our pay, our employees on the pay period, uh, whether it's weekly, biweekly, semi-monthly, monthly, whatever it is, we want it to be as frequently as possible for a couple of reasons. One, when that money leaves your business bank account, it's not going to be extremely noticeable and your business will not be hemorrhaging because you took a large lump sum out. Number 2, it's really great for individual cash flow. You know, you match it with your loan payments, your rent payments, your insurance, your groceries. You know, I do it weekly because I think it just matches my lifestyle perfectly. But I also have my mortgage payments, my loan payments all weekly as well. So I can see exactly how much is left in my bank account, which isn't very much. And that's by design. Every single week, we don't want to necessarily be accumulating a whole bunch of cash personally, because if that is happening, we need to take less from the company. Again, the less we take out from the company, the less tax that's being paid, the more we can reinvest in wealth and accumulating investments inside our company. So establish a budget, understand how much you need, keep it as low as possible, and then fix that amount and take it out either as a salary or dividend, whichever one makes the most sense for you. Typically it's going to be taking dividends out. It's going to make more sense for a business owner because of the tax rates, because of not paying Canada Pension Plan, or in the US paying any of your payroll-related taxes. Taking a dividend distribution is likely going to make more sense for you. So budget, Come up with the amount, pay that out weekly, monthly. That's going to be the best way to continue to have that for you, for your family, for your business, from a cash flow management standpoint. Now here's where it gets interesting. If you can actually hold to that. All right. So let's say again, it's $1,000 a month is our net income. That's what we need to live. I know that's not realistic for anybody, but it's, you know, For simplicity, that's the number I'm going to use. You take $1,000 out. Let's call that a week, $1,000 a week. You take that out and you spend it completely. There's nothing left. Okay. Let's say the business continues to grow and let's say we get it so that it's $2,000 a week. The idea would be that you continue to maintain your lifestyle at $100 or at $1,000 a week, the extra $1,000 a month. Or a week that you're creating in your business, you start investing it. Now you invest the $1,000 at 5%. Let's say it's going to start generating passive investment income. Now that passive investment income is not going to be very much. It's going to be $50 a year, right? But, and let's just say it's $50 a week that we're going to generate. So instead of $1,000, you're now going to have $1,050. You reinvest the next $1,000. Now it's going to be $1,100. You reinvest the next $1,000 of surplus. Now it's going to be $1,150. So the idea would be that you maintain your lifestyle. And as your business starts to earn more money, you reinvest all of that surplus, but you create passive investment income from those investments that then supplement the increase in your lifestyle. Now that's a great way to do it. If you want to take it one step further, Don't take those funds out and supplement your lifestyle. Resist the urge to spend more money and reinvest the passive investment income and grow your wealth extremely fast. Now, maybe you take half of the income, right? The $50 that we're generating in passive investment income, $25 of it goes to you, $25 gets reinvested in your wealth accumulation strategy. If you're able to put all of those things together, that's how you're going to become a millionaire in a really fast way. And I will do another podcast in the future about just how we can become a millionaire in less than 4 years. I've got a breakdown of how this works, um, from your business where it is now to being a millionaire in 4 years. But you have to resist taking that money out now, and you have to resist taking it out until you become the millionaire. And that's where it becomes challenging. As you make more money, it's definitely challenging to make sure that you, you continue to be responsible and leaving it in or reinvesting in everything that goes that way. Okay. Let's talk about the separation of personal and business expenses. So, you know, we've got our salary, our dividend, whatever that looks like. We've got our consistent money flow that's coming in. We're paying our bills. We likely don't have much left. Unless we're cutting our bills down and unless maybe some of the plan is to have some personal investments, I've advised that it's better to leave them in the company, but to each their own. Sometimes people just want to have a little bit more of a stockpile or a nest egg in there. The key idea is too, as part of this, that there is complete separation between business expenses and personal expenses. Business expenses stay in the business. This is any expense that you incur to generate business income for the future. Leave those funds in the business, deduct it. It saves taxes. Any of your personal expenses that you're paying for personally, not really deductible. There's a few things, you know, health-related items, dental, donations, charitable contributions, items like that. But for the most part, if it can be written off as a business expense, we want to do that. We don't want to push the limits beyond what the line is, but we want to make sure that we're taking advantage of everything that the legislation says we can. Okay, put those in the business. That's a business deduction. Let's minimize the amount that comes out to us for our personal income. So as you can tell, some of the personal income tax or personal income strategy and planning, whether it's dividends or whether it's salary, impacts personal tax calculations as well. I mentioned to you that salary has higher tax rates personally because the business won't be paying as much tax. Any of the savings the business gets, you're likely paying for it with a higher personal tax rate. If you're taking dividends out, the business is not getting a deduction. It's paying higher taxes, but you individually are paying less taxes as well. So there is, you know, again, if we calculate this, it does make sense in many cases to do a dividend distribution versus salary, but sometimes you have other considerations. And we're happy to, to walk through any of those as well. So just to recap, and I'm going to end it right after this, if you have an entity that is a proprietorship, you pay tax based on the income that's earned in the partnership or the proprietorship. Doesn't matter how much you take out. You can take it all out. You can take out more than what they had available. Whatever it is, you're paying tax on the income the sole proprietorship or the partnership is earning. If you own a corporation, The corporation is paying tax based on the net income that the corporation is earning. Similar, right? But there's a secondary piece that if you're taking money out as a salary, the business gets a deduction, saves you in tax, but you pay that savings back personally as part of your salary tax. If the business is earning income and you take out a dividend, the corporation is going to pay tax. You personally are going to pay slightly less tax. Than you would have with a salary. Now, part of this is making sure that we're optimizing the corporation's tax to corporation. If you're a small business corporation, Canadian-controlled tax rates are 12% across the country. In the US, they're 21% in a C corporation, fixed fee. If you're paying more tax than that personally, then you should be leaving the money in the business and paying a dividend distribution. It will keep your taxes down as low as possible. If you are like me and you're not really desiring to contribute to Canada Pension Plan, you can't take a salary. You need to take dividends. It will put about $7,000+ back into your pocket for you and any other family member that's taking a salary, and you can invest that inside the company and start your wealth accumulation plan. Ultimately as well, we want to remember the more money we leave in the business, the less tax we pay, the more money we leave in the business that we can invest. Faster, we're going to accumulate our wealth. We want to create a fixed withdrawal from the company, whether it's a salary or a dividend, and we're only going to take out the, the maximum amount we need to pay our bills. We're not going to take out anything more than that because we're going to reinvest our wealth inside the corporation and get that wealth accumulation track going. And the idea is, you know, the next level, the 2.0 version is if you can maintain that salary or that dividend amount, whatever funds you're taking from the corporation, maintain that while you start growing your business and your income. Any surplus can be reinvested back into the business. And then you can either pull out the investment income and supplement your income to bring it up, or you can leave, you know, a portion or all of that in the business and maximize your wealth accumulation. Guys, this has been a podcast on how to pay yourself as a business owner. I hope it's been extremely valuable. I hope it brought together some insights. This is really, if you can stack all of these things together, this is going to maximize your wealth as a business owner. And if you have, and if your business is a side hustle, incorporate it and leave all the side hustle money inside your corporation. You know, you're going to pay a small amount of tax inside the corporation, but you're gonna be able to save all of that money and put it away. And then my last piece was if you're going to invest into investments, make sure that you're minimizing the tax that you have to pay in the short term. So that's deferred and it helps to reinvest in that investment for the long term. And when you sell it, you pay capital gains tax, which is going to be the best tax rate that you can possibly get access to. Guys, this has been the Wealthy Entrepreneur Podcast. I am your host, Bob Gauvreau. It's been a pleasure. We are here to make sure that we're empowering business owners to have the financial clarity and confidence they need to be financially successful. And that financial success allows us to continue to make a positive change in the world together, to create great strong businesses and create a really great community that supports one another. So really proud to be part of that, designing that and delivering information that can help support that. If there's any information in here that you have found that you think another business owner would feel valuable, please share this out. Tag them in it. Also leave a comment, pose any questions, happy to answer any of those that are there. Most importantly, give us a like. Uh, we're going to continue to drive good content for you, valuable resources, have great conversations with other entrepreneurs, talk about what's worked, what hasn't, ultimately learning from the experience of those who have already done it so that we can make our journey that much more successful. Regardless, it's been a pleasure to have you with me today, and I look forward to having you again next time.