Paying You: How to Pay Yourself When You’re the Business Owner

Freelance consultants and business owners dedicate a considerable chunk of mental bandwidth to thinking about how to generate business, because the top line matters. We think a lot about making money, but we may not devote much time to thinking through the mechanics of paying ourselves once the money arrives.

Sole Proprietors and single person LLC owners may consider the self-payment process a no-brainer—as invoices are paid, one simply deposits the money into the business bank account. But like so may actions that seem easy at first glance there is usually a right way, a smart way, to pay oneself as a self-employed person.

So—are you on your business’ payroll or do you take payments from your business in the form of owner draws? Do you and your business partners take guaranteed payments (salary)?  Are you paying yourself too much or not enough? How can you tell? Also, where in your business financials are the payments recorded?

Business type Payment Tax return Payroll Tax

Sole Proprietor Owner’s draw         1040/ Sched. C     Yes                                

Single LLC Member draw 1040/ Sched. C Yes

Multi LLC Member share 1040/ Sched. K-1 Yes

S Corporation Dividend/ wage 1040/ Sched. K-1 Yes

C Corporation Dividends 1040 dividends not on dividends

Sole Proprietor

Business owners and Freelancers who adopt this, the default business structure, pay themselves through an owner’s draw, i.e., the amount of money taken from business earnings, after expenses and taxes, by the owner for his/her personal use. The payment is called a draw because money is drawn out of the business.

Sole Proprietors usually take draws by writing a check to themselves from their business bank accounts. Smart Sole Proprietors will then deposit that check into a personal bank account and avoid co-mingling business and personal funds, a practice that inevitably leads to accounting and tax complications. The owner’s draw doesn’t affect business taxes because the net income has already been taxed. The draw is also not a business expense. From an accounting and tax perspective, the owner’s draw is income distribution. Owner draws are recorded on the Balance Sheet.

Limited Liability Company (LLC)

LLC owners, who are known as members, are not (always) considered employees of the entity and therefore they do not (always) take a salary as would an employee. LLC members, especially single member entities, usually pay themselves with a member’s draw, which is taken from the member’s capital account (business bank account). Multiple owner LLCs are considered to be partners in the business and pay themselves with a member’s share distribution, also taken from the member’s capital account. 

While members may periodically draw from their capital account, a draw is in reality an early withdrawal of anticipated year-end profits, a goal that is perhaps at top-of-mind at multi-member LLCs. Whenever a member receives a draw during the year, his/her capital account decreases, but if the business shows a profit at the end of the year, the member’s capital account will increase in accordance with the percentage of ownership. If a member owns 25 % of the LLC, then s/he can expect to receive 25 % of year-end profits. Single member LLCs own 100 % of the entity and are entitled to 100 % of the profits. Member draws are recorded on the Balance Sheet.

A working member in a multi-member LLC has the option of either receiving a guaranteed salary amount as an LLC employee, or paying oneself with a member’s share distribution, as will a single member LLC owner. Members who are strictly silent partner investors and do not work in the business are not entitled to period draws, but will receive their member’s distribution of profits in accordance with their ownership percentage at the end of the tax year. 

The member salary, known as a guaranteed payment, is not based on the percentage split agreed upon in the LLC operating agreement but based on the work the member performs in the business. Unlike member distributions, guaranteed payments are recorded on the Profit & Loss (Income) Statement and are taken from business profits.

The LLC must be diligent about filing the correct tax forms on behalf of members and maintain accurate accounting histories for everyone throughout the year, to reflect member payment choices. Members paid as LLC employees must file IRS Form W-4 to calculate the amount of payroll tax withholding taken from from each paycheck. The member is then treated as a W-2 employee of the LLC. If the member is paid as an Independent Contractor, then s/he must file IRS Form W-9 with the LLC and the LLC must file IRS Form 1099-MISC by the end of the year. All member draws or distributions are deducted from the amount of profits assigned to the capital accounts, based on ownership percentages.

Corporations

An S Corporation is in reality either an LLC or C Corporation that has elected for special tax treatment with the IRS. S Corp income, losses, deductions and credits pass through to its shareholders’ personal IRS Form 1040. Shareholders then report the business’s income and losses on form 1040 and are taxed at their individual income tax rates. C Corps are subject to double taxation—a separate corporation tax and when dividends are paid to shareholders, that amount is recorded on IRS 1040 (but there is no payroll tax).

S and C Corporation owners who work in the business pay themselves a regular “salary” and also distribution payments. S Corp owners are usually employees of the business. Owners who work as employees must be paid a “reasonable salary” before profits (dividend distributions) are paid and the salary is subject to payroll taxes. The IRS has guidelines that define a reasonable salary, based on job responsibilities. Salaries are generally taken from business profits.

Owners of C Corps can elect to pay its shareholders a cash dividend, which is a distribution of company profits. However, the C Corp board may choose to retain either the entirety or some portion of business net profits and decline to pay a dividend in a given quarter or year. If a dividend is paid, that amount is added to income reported on the shareholder’s personal IRS Form 1040. The company records dividend payments on the Balance Sheet.

S corporation owners have been known to request that their corporations pay them little or no salary, since salaries are taxed, and instead take payments as dividend distributions, which are not taxed. The IRS has stepped up enforcement on this issue and in 2000 audited thousands of S Corps whose owner the IRS concluded had received a suspiciously low salary and very generous dividend distribution, in an apparent attempt to evade payroll taxes by disguising their salary as corporate distributions.

Thanks for reading,

Kim

Photograph: Pay day on a U.S. Navy cruiser (1942)

Face Your Financials

Although you may have both an accountant and a bookkeeper on your payroll you, the business owner,  still bear the ultimate responsibility for maintaining the financial health of your enterprise.  Every business owner should be able to understand and make good use of business financial data.  Each financial statement has a story to tell and you the business owner must be able to decode the language and comprehend the information that the numbers relay.

There are three financial documents that are generated monthly  (and also compiled quarterly and annually): the Balance Sheet, the Cash Flow Statement and the Profit & Loss  (or Income)  Statement.

  • The Balance Sheet resembles your checking account monthly statement.  This document details business assets and liabilities,  showing the monetary value of all the business owns and what it owes.
  • The Cash Flow Statement is the business budget and shows what sales revenue will flow into the business and what expenses will flow out.  This document helps you stay on top of how much money is available to cover expenses,  like payroll and rent.  Accounts payable  (the bills)  and accounts receivable  (sales revenues)  are listed on this statement.  If you’ve ever managed a household budget,  then you can master the Cash Flow Statement.
  • The Profit & Loss  (or Income)  Statement is similar to the Cash Flow Statement.  It contains many items that are also found on the IRS tax form Schedule C,  Profit or Loss From a Business.  Sales revenues and expenses are listed on this statement,  including labor,  taxes,  inventory  and the wholesale costs of products sold.  Net Profit (also known as the bottom line)  is  the last line of this statement and this figure represents the ultimate story of business financial health.

One does not need a degree in accounting or an MBA in finance to identify which numbers on financial statements are most critical to your business and understand the story that each one tells.  Keeping track of five or six key values,  including values called ratios,  will do wonders for your comfort level with financial analysis and in the process,  guide your business decisions in many ways.

  • Gross Profit  in the P & L tells how much money remains after selling and product production costs,  or the wholesale cost of products sold,  have been tallied.  Freelancers calculate this figure as time: how many hours were spent on your contract project,  networking to create new business,  developing a new workshop? Make a reasonable estimate of the wholesale cost of your labor.  This figure gives insight into how much money/time  it takes to make a sale.  Can you work smarter and faster,  or buy materials for products manufactured more cheaply? That’s how to increase gross profit.
  • Net Profit,  or the bottom line of the P & L,  tells the ultimate story.  Every line item that precedes it impacts it.  If you want that number to be larger (and don’t we all?),  look at all expenses to see what can be trimmed and also consider ways to generate new business through strategic partnerships,  referral relationships,  networking for client development,  PR,  etc.
  • Gross sales revenues  in the P & L may be tracked in two ways,  looking back over what occurred in previous months or years  (historical comparison)  and going forward  (projections, or forecasting)  to what you reasonably expect and want to sell in a given period,  guided by sales history and current demand for your product/service.  Are you achieving,  exceeding or failing your personal sales goals?

Finally,  see your Balance Sheet and calculate these ratios,  to expand your grasp of the financial data:

  • Quick Ratio = Accounts Receivable + Cash – Inventory divided by Accounts Payable    This figure indicates how much money is available to pay bills.  A 2:1 ratio represents a business in good shape.  However,  a big receivables number can mask clients who take longer than 30 days to pay,  thus signaling the owner to step up collection efforts.
  • Current Ratio = Assets divided by Liabilities   This figure measures resources available to pay debts over the next 12 months.  A value > 1.0 shows a business in good shape,  > 2.0 is a business in excellent shape.
  • Working Capital = Current Assets – Current Liabilities   This figure also demonstrates the ability to pay off short-term debts.  Obviously,  a positive number is what you want.
  • Debt to Equity Ratio = Total Assets divided by Total Liabilities   This figure indicates how much debt the business carries relative to its assets.  A value <0.5 is excellent and values > 0.5 mean the business is carrying rather heavy debt and is considered highly leveraged.

Thanks for reading,

Kim

When to Hire a Bookkeeper

Occasionally,  I am asked to refer a bookkeeper.  The one time I was able to make such a referral,  the whole thing blew up in my face.  I introduced a former  student in the business plan course that I sometimes teach to a restaurant owner friend.  Unfortunately,  Ms. bookkeeper  flaked out and never came through.  The restaurant owner and I are still pals, thank goodness.  The bookkeeper’s contact info has been deleted from my files.

A couple of months ago,  a member of one of the CEO forums that I lead hired a bookkeeper whom I’ve known for 20 years (the referral was not mine).  Because my colleague is a smart cookie,  she decided to review the financial statements that were generated by her new bookkeeper.  Right away,  there was a problem.  A significant data entry error was made— yet somehow the bookkeeper managed to make the numbers balance.  Fortunately,  my colleague  was able to recognize the problem and call  it to the bookkeeper’s attention.

The interesting thing is,  her now former bookkeeper is highly regarded by many.  She has a sub-specialty in forensic  bookkeeping and regularly testifies in court proceedings.  So I guess that’s where she learned all the tricks! My colleague was mortified.  Thank God that was not my referral.

I deduce from these incidents that a  reliable bookkeeper may be difficult to find.  A sharp and trustworthy bookkeeper is a hugely valuable  asset for your business.  They can spot and resolve  money drains  and alert you to money saving practices  that you never knew existed.  A good bookkeeper is worth their weight in gold.

Like many Freelancers,  I keep my own books.  I  invoice,  make  deposits,  pay bills,  record transactions in Excel,  receive the 1099s and pay the taxes.  June 15 is fast approaching, quarterly tax time folks!  I manage to stay on top of things.

Nevertheless,  at some point it may become too expensive to perform certain administrative tasks.  Working and looking for work are the primary focus of the self-employed.  Our time and energy are best applied to making sales calls,  networking,  prospecting,  staying visible and generating income through our projects.  When administrative tasks encroach upon the time available to make money,  it then becomes  cost  effective to outsource those functions.

It is the responsibility of every business owner to develop a basic understanding of the  financial statements.  Our ability to make sound business decisions depends upon it.  A good bookkeeper (and accountant) will further analyze the data and provide more sophisticated advice for you.

Because they possess intimate knowledge of your financial history and flow of business capital,  bookkeepers know where you are most vulnerable and know  where the bodies are buried.  A dishonest or sloppy bookkeeper can really hurt you.  The best way to protect yourself  is to know what’s  going on,  so that like my colleague,  you can read  financial  statements and periodically review your bookkeeper’s  work.  You’ll  have a fairly good idea of what the numbers  should  look  like and know what questions to ask  if  things don’t quite add up.

To get started on the path to understanding financial docs,  I recommend  that  you  first examine the Pro Forma Cash Flow statement.  It’s like  a  household budget and is easy to read.  Pro Forma Cash Flow gives  reasonable  estimates of expected business income and expenses  for  a given month.  Go next to the Cash Flow Statement,  which might be generated either monthly or quarterly.  This document shows what was actually spent on business expenses and how much money was actually paid to you.

From those statements,  move on  to the Profit and Loss.  It’s  not much different from the Cash Flow Statement.  Notice that several categories on the P & L are also found on the  Schedule C tax form,  Profit or Loss  From a Business.  Lastly,  take a look at the Balance Sheet and notice it’s resemblance to a bank statement.  The Balance Sheet records your net worth at a given time,  the tally of business assets and liabilities,  and is usually generated quarterly.

Next week,  learn what you can do to make sure that the bookkeeper you hire is both a top drawer professional and appropriate for your business needs.

Have a good week,

Kim

Starting A Business? Consider Your Financials Part II

Learning to create the financial documents for your business  is a worthwhile endeavor.  Make yourself do it! You will gain a significant understanding of your business.  You will learn the art of financial analysis.

Retaining a bookkeeper and accountant to produce the monthly statements and prepare the taxes is not enough.   In most cases, they don’t know your business well enough to make important decisions.  They can tell you when to cut expenses, but they lack the hands-on overview that effective decision making requires.

That responsibility (and privilege) is yours alone.  Little by little, even those who may be intimidated by numbers can become comfortable with the process.  Every business owner is the company CFO.

THE PROFIT & LOSS (INCOME) STATEMENT

This statement demonstrates whether or not the business is making money.  It will be useful to generate  a P & L statement every month, to chart your progress and help you pay attention to what the numbers are telling you.  It is an excellent analytical and decision making tool.

Many entries from the Cash Flow statement will also be listed in the  P & L:  sales revenue generated from each product and service;  variable selling expenses such as raw materials, labor, equipment rental and advertising;  and fixed costs such as rent, office staff salaries and utilities.  When you’re financially able to do so the owner’s draw,  i.e. what you pay yourself, will be listed here as a fixed expense.

At the top of this statement, enter gross revenues (sales). There are also lines for beginning and ending inventory and cost of goods sold.  Subtract COGS from gross revenues to reveal the gross profit.

Fixed and variable  expenses are tallied and subtracted from gross profit earnings to give you the EBIT: earnings before interest and taxes.  Loan interest payments and all taxes are then entered and subtracted also, to reveal in the bottom line of the statement the net profit or loss.

THE BALANCE SHEET

The Balance Sheet shows the financial picture of your business on a particular date.  It demonstrates what the business owns and owes on a given date, usually at the end of the fiscal (or calendar) year.

The Balance Sheet is divided into 3 categories:  Assets,  Liabilities and Net Worth (owner’s equity).  All business assets such as cash in the bank,  equipment owned,  inventory, property owned, office furniture and accounts receivable are considered assets and are entered in the plus column.

Business debts and obligations, e.g. loans and loan interest payments, accounts payable and taxes owed are entered into the minus column.  Net worth emerges when liabilities are subtracted from assets.

THE QUARTERLY BUDGET REVIEW

The Pro Forma Cash Flow statement, which provides a projection of what cash can reasonably be expected to flow into and out of your business in a given month (or quarter), should be validated by a Quarterly Budget Review.   Also called the Cash Flow Statement, this document gives the actual cash flow numbers for your business and is created after the fact.

Now you can compare your best guesses to reality.  Are you over or under budget? What has been over- or underestimated? Do you need to trim or stagger certain expenses in order to pay the bills every month? How accurate were your sales projections? Moreover, how much are you spending to make the sale?

Needless to say it will benefit you to trim expenses wherever practical and control COGS by locating the lowest cost wholesalers and raw materials sources, to free up cash so you can comfortably pay the bills each month,  pay down business debts and  perhaps  allocate money for useful promotional and advertising campaigns. You will also want to take that owner’s draw as soon as possible!

We’ll conclude the money portion next week with a look at what investors and lenders will also want to see.

Kim