Compensation vs distributions: getting the balance right

When you’re an owner-manager of a business, it’s important to find an acceptable level of compensation to pay yourself. But’s it’s equally important to balance the regular wages you pay yourself against the cash and dividends you take out of the business as a director – the ‘distributions’, to use a little accounting-speak.

Paying yourself the right wage and the right level of distributions has a significant impact on the tax you pay, the profits you’ll see from the business and the overall financial health of the business.

How, then, do you get the compensation vs distributions balance on point?

 

Understanding compensation vs distributions

First off, let’s make our terms absolutely clear with a great quote from Greg Crabtree in his excellent book for entrepreneurs ‘Simple Numbers:

“All of my clients have confused the profits of their business with their salary. Remember this key distinction: You get paid a salary for what you do, and you get a return on what you own.”

So, to break that down even further

  • Compensation = the regular monthly salary you pay yourself to live on.
  • Distribution = the money or other assets you pay yourself from the business’s profit – the return on your investment.

This is an important distinction to get your head around, as the tax treatment of compensation and distributions is different. And that means there’s a real imperative to review and analyze your salary and distribution numbers to ensure you’re being as tax-efficient and as profitable as possible.

For example, owners of Subchapter S corporations (S corporations) have the ability to be taxed at the shareholder level (your wages) rather than at the corporate level (paying corporation tax on your profits).

So to maximize the efficiency of any tax planning, it’s vital to meet the IRS’s conditions for the S corporation tax break, but to also make sure you don’t over or under-pay yourself within these strict guidelines.

Paying yourself a market-based wage

Paying yourself a realistic, workable wage is one of the most important things to get right as an entrepreneur.

Until you have a market-based wage coming out the business, your financials don’t even begin to stack up. Revenues are an important part of understanding the business’s overall turnover, but your monthly numbers mean nothing until you’ve subtracted a living wage from the cash in the business.

To coin a well-worn phrase, ‘Revenues are for show, profits are for dough’. And once you understand the need for that genuine, market-based salary it’s very clear that your wage costs are a fundamental part of your profit numbers.

Revenue – Owner salary – Other operating costs = Your REAL profit

And if that owner salary number is underplayed and doesn’t reflect the market, you get a falsely inflated view of your profits.

In short, your financials will lie to you – and that’s a terrible position to be in when making critical business decisions or working on longer-term growth plans for the company.

The dangers of substituting distributions for salary

As we mentioned in our last blog, understanding each variable in your Acceptable Level of Profit (ALP)  is business critical. And your salary is a significant variable in this profit equation. Change it, and you don’t just affect your wages; you affect the entire nature of your ALP and your projected sales targets.

As an S corporation owner, there’s a temptation to underpay yourself and to therefore pay less in tax to the IRS – and to make up the cash shortfall in distributions from the business.

But that’s taking the short-term view – something that rarely works well for a true entrepreneur. Underpaying yourself may reduce what you pay to the IRS in the short term, but in the longer-term it will impact on your profits and affect the overall financial efficiency of your business.

To work that into the simplest overview:

Underpaid salary + Money taken as distributions = LESS end profit

And as any good entrepreneur will tell you, profit is the lifeblood of your organization and the fuel that will continue to drive the company forward into the future.

Scenario-plan and measure your compensation and distributions

So, we know that there’s a fine balance between salary (compensation) and profits you pay yourself (distributions). How, then, do you work out the right balance between the two and find a market-based salary that works and a distributions number that doesn’t eat into your yearly profit figure?

The answer is to look ahead and to scenario-plan a variety of different compensation/distribution ratios to see what the impact will be on your profit numbers. This kind of forecasting allows you to ask the all-important ‘What if I pay myself $X a month…?’ questions and, by using the ALP equation, to see the impact on your profits.

This could be as basic as plugging the numbers into an Excel spreadsheet with the relevant formulas in place. Or it could be as specific as using one of the many cloud-based forecasting solutions on the market to get extremely detailed, granular breakdowns and data visualizations of all your projected compensation, distribution, costs, tax and profit figures.

Whichever method you opt for, the important point is to put some serious consideration into the ratios between your salary and your distributions.

And once you have a workable balance, keep measuring those numbers over time and keeping a very keen eye on how they’re impacting on profits.

Get a real return on your investment

The better you understand your compensation and distributions ratios, the better shape you’re in to keep your business profitable, your return on investment looking positive and your own underlying wealth in a stable and secure condition.

At Holden Moss, we always take a holistic approach to advising our owner-managed business clients. We never deal with one element of your financial management in isolation; we always look at the whole picture and the impact that any changes will have on the company, your future success and your own personal wealth.

This holistic approach is the bedrock of our Awesome 8 approach to business advice – find out more about protecting your wealth here.

Contact your local Holden Moss office and let us help you get your salary and distribution payments balanced and driving your profits.

Written by

Steve Moss, CPA is a partner at Holden Moss CPAs and loves helping businesses and their owners grow to be the very best they can be. Our other offices include Raleigh, Oxford and Warrenton. We are a little different at Holden Moss CPAs. While we still provide traditional tax and accounting services, years ago we realized many clients wanted help in running their businesses and were hungry for ideas, solutions, strategy, and execution. In response, we expanded our skill set and joined Ran One, a global network of business consulting firms. Our membership with Ran One gives us access to proprietary resources and analytical software to help our clients grow, become more profitable and valuable, and have the lifestyle they desire. Now, blended into the fabric of our normal tax and accounting needs, we are focused on our clients’ businesses in a very different way. While our approach is not right for everyone, for those whom it is, incredible results may be obtained. Whether you have a new, or established, business, or for those in transition of selling or retiring, or for those who simply need to develop an exit strategy or succession plan, our unique approach to client service may be the edge you need.

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