How to Pay Yourself as a Business Owner in Kenya
If you are wondering how to pay yourself as a business owner, welcome to the club. This is a question a lot of business owners grapple with as they try to balance their personal financial needs and growing a business.
This article will guide you through the essential considerations and legalities of paying yourself, whether you operate a sole proprietorship, a partnership, or a limited company. Understanding how to structure your compensation effectively will not only ensure compliance with Kenyan laws but also support your business’s sustainability and growth.
First things first, you need to understand the legal structure of your business as it determines how you can compensate yourself. I covered that in this article. However, here’s a quick breakdown of the common legal structures business owners choose.
It’s important to note that this is a simplified overview. The decision of which structure to choose depends on various factors like your business size, risk profile, and future growth plans. Are you starting your business and don’t know what option to choose? I recommend working with a qualified accountant or legal professional to help you determine the most suitable structure for your specific situation.
Sole Proprietorship
This is the simplest and most common structure for new businesses. As a sole proprietor, you and your business are considered one legal entity. There is no formal separation between your business and your personal taxes and liability.
That said, it’s important to separate the finances for easier management, accountability, and tax reporting. Ensure that you have a separate bank account for your personal finances and one for your business finances.
Partnership
A partnership is a business co-owned by two or more people. Partners share in the profits and losses of the business according to a predetermined agreement. There are two main types of partnerships:
- General partnership – in a general partnership, all partners share equal responsibility for the business’s debts and liabilities. This means that if the business cannot meet its financial obligations, creditors can come after your personal assets.
- Limited Partnership – a limited partnership offers more protection for some partners. In this structure, there are two types of partners: general partners who manage the business and have unlimited liability, and limited partners who contribute capital but have limited liability (usually restricted to their investment).
Private Limited Company (LTD)
An LTD is a separate legal entity from its owners. This means the company has its own tax obligations and financial records. You can be both the owner (shareholder) and an employee of the LTD.
How to Pay Yourself as a Business Owner in Kenya
As mentioned earlier, how you compensate yourself as a business owner depends significantly on the structure of your enterprise. It’s important to grasp the distinction between the available options. Each has specific applications and legal stipulations depending on your business type.
How to Pay Yourself as a Sole Proprietor
For sole proprietors, the primary method for compensating yourself is through owner’s drawings. This refers to the process of withdrawing money from your business account for personal use. The drawings could be from the profit your business generates, the capital you contributed toward the business or a combination of both.
Below are some of the key characteristics of owner’s draw:
- Flexibility – There are no set rules on how much or how often you can take an owner’s draw. The flexibility allows you to adjust your compensation based on your business income and personal needs. For instance, if you have a personal investment or project that requires a significant amount, you can draw funds from your business to meet this need.
- Tax implications – since you and your business are considered one entity, all business profits, including owner’s draws, are reported on your personal income tax return. You will be taxed on the total income you withdraw from the business.
- Record-keeping – it’s important you maintain clear and accurate records of your owner’s drawings. This includes documenting the date, amount, and purpose of each withdrawal. Proper record-keeping simplifies tax filing and helps you monitor your business’s financial health.
Unfortunately, there are no set guidelines on how to handle owner’s drawings. However, here are some recommended practices for managing owner’s draws:
- Set a budget – determine a realistic and sustainable amount for your owner’s draw based on your business income and projected expenses.
- Maintain separate accounts – while a separate business bank account isn’t mandatory for sole proprietors, it’s highly recommended. This separation helps track business income and expenses and simplifies record-keeping for owner’s draws.
- Consistency is key – develop a consistent approach to taking owner’s draws. This could be a fixed monthly amount or a percentage of your business profits. Consistency helps with budgeting and financial planning.
How to Pay Yourself in a Partnership
With partnerships, the most common method for compensating partners is through profit sharing. Profits are shared amongst partners according to a pre-determined agreement outlined in your partnership deed. This agreement should specify the percentage of profits each partner receives.
There’s no one-size-fits-all approach to profit sharing. Profit sharing percentages can be based on various factors such as:
- Capital contribution – partners who contribute more capital to the business may receive a larger share of the profits.
- Time commitment – partners who dedicate more time and effort to managing the business may be entitled to a larger share.
- Expertise – partners with specialized skills or experience crucial to the business’s success may receive a higher profit share.
Similar to a sole proprietorship, it’s important to maintain clear and accurate records of profit distributions. This includes documenting the date, amount, and basis for each profit distribution to each partner.
Each partner’s share of the profits is considered personal income and reported on their individual tax returns. You will be responsible for paying taxes on the portion of the profits you receive.
How to Pay Yourself in a Private LTD Company
If your business is registered as a limited company, you may opt to pay yourself a salary. Unlike an owner’s draw, a salary involves setting yourself up on the business payroll. This method is more structured, as it treats your compensation as an expense to the business.
1. Salary
Unlike owner’s drawings, paying yourself a salary provides a consistent income stream for your personal finances, similar to a traditional employee-employer relationship.
However, keep in mind that salary payments are subject to PAYE (Pay As You Earn) and other statutory deductions, like the National Social Security Fund (NSSF), National Hospital Insurance Fund (NHIF), and Housing Levy. this means that you must withhold and remit these deductions to the necessary bodies before the applicable deadlines.
On tax treatment, salary and other employee benefits you might have are treated as a business expense. These help reduce your business’s tax liability.
There are no strict guidelines on how much salary to pay yourself from your LTD. However, the salary amount should be reasonable and commensurate with your role within the company and market range. Whatever amount you choose, ensure it’s a sustainable option for your business.
2. Dividends
If your business is incorporated and you hold shares, you may opt to receive dividends as part of your compensation. Dividends are paid out of the profits, and thus, their availability and amount can fluctuate based on the business’s profitability.
Dividends paid to shareholders are subject to a withholding tax, which is usually deducted at the source by the company issuing the dividends. Although the tax on dividends is withheld at the source, you must still include these earnings in your annual personal income tax returns.
What’s the Best Option for You?
Many business owners find that a combination of these methods is an ideal option. For example, you might take a modest salary to cover regular expenses and then supplement it with dividends during more profitable periods. This hybrid approach allows flexibility while providing a stable base income.
Planning and Compliance
Regardless of the payment method you choose, it’s important to optimize your tax liabilities and ensure compliance.
Tax management is overwhelming, especially for non-accounting business owners. Additionally, tax laws and rates can change, and it is important to regularly review your compensation strategy and tax planning to ensure they remain compliant and effective under current laws. That’s why you must consider consulting with a finance or accounting, like a tax accountant to help navigate the complexities of tax planning.
Best Practices to Determine Fair Compensation
Determining how much to pay yourself as a business owner requires careful consideration to ensure that your compensation aligns with both your personal needs and your business’s health. Here are some best practices to guide you in setting up your compensation effectively:
Align Your Compensation with Business Performance
What image comes to mind when you think of paying yourself as a business owner? Is it earning an income that allows you to drive around with the latest model of your dream vehicle? While it’s a valid dream, is it sustainable for your business?
It’s important to be realistic. Regularly review your business’s financial statements to understand its profitability and cash flow. Then, base your compensation on realistic expectations of what the business can afford. Paying yourself too much can strain the business’s finances while paying too little might affect your personal financial stability.
Whatever amount you choose, your compensation should be sustainable by the business without compromising its growth or operational needs.
Maintain Clear Financial Separation
Keep your personal and business finances separate, especially if your business is a sole proprietorship structure. This separation helps in clear financial tracking and simplifies accounting processes.
Second, ensure all transactions are well documented. This helps in maintaining clear records for tax purposes and financial analysis.
Stay Compliant With Legal and Tax Regulations
Even if you have no finance or accounting background, it’s important to stay informed about the legal implications of your compensation method, especially concerning tax laws and company law if you operate a limited company.
Tax regulations can change, impacting how you should handle your compensation and taxes. Regular updates are necessary to remain compliant and avoid penalties.
Having said that, this can be an overwhelming task. To ensure compliance and reduce stress about handling taxes, consider working with a qualified accountant.
Regularly Review and Adjust Your Compensation
Set an annual review of your compensation structure to adjust based on the business’s performance and changing financial needs.
Consider consulting with a financial advisor or accountant. Their expertise can provide insights into the most effective compensation strategies and ensure that you are maximizing tax efficiencies.
Plan for the Future
Finally, ensure that you plan for the future, not just for the business but also for your personal life. For starters, include plans for retirement savings in your compensation structure. Whether through a personal retirement savings plan or a formal pension scheme, planning for the future is crucial.
Additionally, reinvest a portion of the profits back into the business to promote growth and stability. Balanced reinvestment alongside fair compensation helps create a sustainable business model.
