Owner's Salary vs. Owner's Distribution

cyclecpa.com

There are different motivating factors for starting a green industry business, but making a healthy profit is a result that many business owners shoot for.?Making a high net profit allows you to either live comfortably, or continually invest back into the business for growth. The problem is that many business owners don’t have an understanding of a major aspect of the finances that affect profits, which is the owner’s salary. You may have come across business owners at events, online forums, and other gatherings that boast about the high profits of their business. The issue arises when these same business owners do not understand the importance of paying themselves a salary for the work they perform, plus making the net profit on the business. It’s important to understand that the profits of the business and owner’s salary are separate and distinct. The profit is the return that you earn on your business, and the reward that you as the business owner receive for the risk of owning a business. The salary is for what you do in the business as the business owner. If you are not paying yourself a market based wage for the work you are performing in your business, then your financials are misleading. You are not only distorting the financials, but may actually be operating at a loss. Now you can see, net profit is only part of the story to success.

First, let’s understand the difference between a salary and a distribution/draw. Owner’s distribution is when the business owner takes funds out of the business for personal use, at regular intervals or when needed. Owner’s distribution does not have deductions for taxes, and is contributed by writing yourself a check or transferring funds into your personal bank account. Owner’s salary is a set wage that gets paid each pay period and includes taxes and deductions.

There are legal, tax, and other considerations to consider when determining owner’s compensation. First off, how you pay yourself as the business owner varies depending on your business structure. In a sole proprietorship, your business income is your income and business owners pay themselves through an owners draw. In a partnership, profits or losses pass through to the partners, and they pay themselves through owners draw and/or guaranteed payments. In an S corporation owners can pay themselves a salary, and through shareholders distributions. In a C corporation owners can pay themselves by way of salary, and through dividends. Knowing these requirements for each entity structure is important for establishing the proper owner’s compensation.?

Now that we know the business entity structures that allow for owner’s salary, we can examine the process behind determining the salary amount. Unfortunately, it is not as easy as a simple calculation. There are some general rules of thumb in regards to percentages of profits, or other metrics, that some CPA’s use in calculating owners salary. Every business is different, and what each business owner performs in the business varies, thus making it inaccurate to have one calculation used across the board. Two business owners in the green industry may have similar profits and similar size businesses, but one owner may be absentee with additional managers, while the other business owner may be handling the majority of the management tasks. Its okay to hire managers and other staff to help support administrative functions, but if you want to continue to pay yourself the same salary, then you will need to continue performing tasks worthy of that salary you are receiving. You may think, I’m the business owner, why can’t I pay myself what I want? To start, paying yourself a low salary is a red flag to the IRS, and can often trigger an audit. Paying yourself too much is also not viewed well by the IRS, on top of the fact that your financial reports will not show the true picture of your company.?

The IRS notes that owners must pay themselves a “reasonable” salary in an S corporation. To determine this, you can compare salaries with other companies, compare within your own company, and base it off a hypothetical sale of your company or replacement of yourself and the duties you as the owner perform. The IRS also considers:

- The financial health of the business?

- The overall experience in the industry

- Any economic conditions within the industry

- The location that the business operates in

Remember, paying yourself an owner’s salary only occurs if your business entity allows for it. There are not shortcuts or simplified paths to high profits. Don’t pay yourself a low salary to allow for higher profits, instead understand where you are, and make a plan to improve from there!?

cyclecpa.com