Updated: Jan 25
Some time ago, I met with a client to review the financial results of her business from the past month. The conclusions were not positive and resulted in yet another delay in the business providing her some form of payout. She stared at me hard. Clearly, the news was not what she had hoped and difficult to digest. “I don’t get it! Everyone is getting paid, but me! How and when do I get paid?!”
Most small business owners, especially new ones, appreciate my client’s dilemma and her frustration. Knowing how and when you get paid is one of the greatest stressors in balancing the demands of a new and growing business and the needs of your personal household.
Each business is different, yet when it comes to paying the owner, there are essentially two ways to get paid. For Subchapter S Corporation business owners, a regularly scheduled salary is mandatory. Typically, you see this in organizations where payment of a salary is not difficult to incorporate into the overall expenses of the business and usually does not create undue financial stress on the financial results of the business.
For those who are owners of sole proprietorships or LLC’s, though, your payment comes from what is called a draw. Since you are taxed on 100% of the earnings of your business, any money you pull out of the business is not taxed to the extent you don’t pull out more money than what the business has produced over the course of its existence. There are no regulations around when or how often draws can be made to the business and this fact alone creates confusion and stress for many of us. Below are five tips for setting up a draw, so you know exactly how and when you get paid.
1. Cash Flow is KING!
For those new to running a business, the first thing you learn is the importance of understanding your cash flow. What is the delay between the payment of goods ordered versus receipt of the sale from a customer? What expenses are coming up? Are we behind on collections? Typically this involves developing a cash flow forecast. Knowing the answers to these questions, gives us a basis for understanding with reasonable accuracy the availability of cash to pay the owner and a suitable timing, as well.
2. Monitor the Forecast
Once the cash flow forecast has been prepared, it is critically important to monitor actual results against the forecast, modify the forecast as necessary for reality and allow for modification for draws to the owner too. If for example, it was necessary to pay for an unexpectedly large container of widgets to satisfy an order from a customer, cash that may have gone to the owner is now temporarily unavailable. We don’t know this unless we have a forecast in place and monitor it against actual results throughout the month.
3. Feed Retained Earnings
Retained Earnings is the sum the cumulative net income of an organization less the cumulative draws of the organization. Essentially it is the earnings of the business that have been “retained” for the business. Consider it your business savings account. As money comes in be sure to set aside a certain percentage for your business to retain. This is a great tool to counter the need for taking on debt.
4. Don’t Mix Personal and Business
Too often I see small business owners pull cash haphazardly from their business to cover personal expenses, typically through the use of corporate debit or credit cards. They tend to significantly underestimate the cash coming out and wonder why they cannot draw funds out through other means. I can’t overemphasize the need to keep personal and business finances separate. It is far easier to set a schedule for draws on a regular basis and apply those funds to personal expenses instead.
5. Schedule the Draw
Provided you have a good understanding of the cash flow of your business and have a cash management system in place to guide you, we can schedule the draws. One of the best methods of drawing money out of the business is one I call the 5-10-20-10 system, which is what I endorse with my clients. This system works well, if you have a sense of the annual net income of the business.
For calendar year businesses, it would look like this:
Pay 5% of annualized income (Feb, Mar, May, Jul, Aug, Oct, Nov, Dec)
Pay 10% of annualized income on months when estimated taxes are due (Apr, Jun, Sep).
Pay 20% of actual income in January, part of which is used to pay estimated taxes and retain 10% of actual income within the business.
Essentially, this system allows for the chance of a lower-than-expected earnings year by not paying out 100% of income over the course of the first 11 months. In the example above you would have drawn 70% of available funds, potentially leaving room for a 30% decrease in income without negatively impacting your business’ cash flow.
If gauging your business income is more difficult, this system can be modified to reduce the monthly payouts to provide a 40% – 50% negative fluctuation, if necessary. It also allows you, as the business owner, to create some clarity around how and when you get paid.
Understanding when and how you can pay yourself out of your business can be a frustrating and challenging experience. By applying the tips above, much of that frustration can be removed and you’ll have a far better handle on the cash flow of your business at the same time.
What’s been your biggest challenge with paying yourself from the business? I would love to hear your thoughts in the comments section below.
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In the next article in the Where Do I Start? Series, we address another thorny issue for small business owners: 4 Questions To Ask Yourself Before Hiring An Employee