As the owner and manager of your business you earn income from two sources: the salary you make as an employee of your business and the profit you make as the owner. Conflating the two leads to inaccurate conclusions about the success of your business.
Payroll Is Not Reality
The smart business owner manipulates his or her salary to minimize taxes. One of the most common methods is to keep salary low and profit high(er) and thereby lower FICA taxes. A common opposite strategy is to keep salary high, thereby lowering the “real” profit, in order to maximize 401(k) contributions.
There is no absolute right or wrong approach to setting your salary. Every situation is unique, with lots of moving parts, and you should work with you advisors to craft a strategy that works for you. The mistake that occurs is assuming the salary you pay yourself accurately reflects the true value of your contribution as an employee.
Neither Is Your P&L Reality
If your salary is over or under the true value of your work, then your net income is overstated or understated by the same amount in the opposite direction.
If you want to know the real profit of your business you can do this simple calculation: Actual Salary + Actual Net Income – True Salary = True Profit. Where True Salary is the amount you would have to pay in the open market for someone else to do the job you do.
The True Profit is the number you use to evaluate the success of your business as if you were an outside investor.
An Example
John has owned and managed his distribution business for 10 years. In the last year, the business had $3 million in revenue, a net income before taxes of $300,000, and John paid himself a salary of $75,000 for being the CEO of the company.
A net income before taxes of 10% for a company of this size, age, and industry is OK, but not stellar, and John is relatively pleased with how things are going.
However, John determines that the market value for a CEO of a company in his industry and of his size is $150,000 a year – $75,000 more than he pays himself. His company’s True Profit is: $75,000 + $300,000 – $150,000 = $225,000. Or 7.5% of revenue before taxes. Not so great and John has some work to do.
What Does It Mean?
You can only evaluate the success of your business if you use accurate information. The first step is to stop thinking of your salary and your profit as one pot of money.