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Owner compensation can be a difficult topic. It's emotionally charged because it impacts both personal and business financial health. Even financially sophisticated owners struggle to discuss it openly. It's also one of the few numbers in the business that nobody outside the business holds you accountable for, which is exactly why it tends to drift. The fix, though, is less complicated than the discomfort around it suggests. Owner compensation has a structure that works, and it isn't the one most owners fall into by default. Getting it right changes what your financial statements tell you and what a lender or buyer sees when they read them.
The Most Common Owner Compensation Mistake: Paying Yourself What's Left Over
The most common mistake we see owners make when paying themselves is taking whatever's left over. Cash is tight; they don't pay themselves enough. Cash is abundant; they overpay themselves. Neither situation gives you a clear picture of business profitability. It also complicates cash flow forecasting because one of your largest outflows becomes lumpy and unpredictable, making it harder to understand the implications of your business decisions. The goal is predictability, for both you and the business.
How LLC Owners Can Pay Themselves: Salary, Guaranteed Payment or Distribution
Most small- to medium-sized businesses are LLCs, which give owners a few different ways to compensate themselves. The most important thing to remember is that you'll be taxed on the profits of the business, whether you leave them in the business or take them out. Taking those profits, or that net income, out of the business is called an owner distribution. Before that owner distribution, you want to pay yourself some kind of regular payment, like a salary. If your LLC has made an S election, you can pay yourself a traditional salary, a W-2 wage like you would earn working for another company, and there's a potential self-employment tax savings under this structure. If you haven't made an S election and you have multiple members, then your LLC can pay you a guaranteed payment, a regular, recurring payment that is deductible from the net income of the business. Single-member LLCs that haven't made an S election are limited to using the owner draw, which is just another name for a regular recurring owner distribution.
Whichever mechanism you use, the underlying discipline is the same. The payment runs on a schedule, it comes out of the business the way any other recurring expense does, and there's a clean separation between the business's money and your own. Buyers read that separation as a sign the business is being run professionally. Owners who are just taking cash out whenever they think there's enough in the account don't present as clear a picture that the separation exists.
How Underpaying Yourself Overstates Profitability and Hurts Your Valuation
Owner compensation that has been improperly structured can get in the way of understanding the profitability of your small to medium-sized business. Doing $200,000 worth of work and paying yourself $50K can make your financials look great, but you've overstated the financial statements. Those profits aren't real. When lenders and investors come in and want to take a look at your financial statements, they're going to ask a lot of questions. When they get to the bottom of this and understand you're underpaying yourself, they're going to have to do some additional work to find something that's consistent with the market and normalize your financial statements making the borrowing process or the investment process take even longer.
The same math works against you at a sale. Inconsistent comp makes the business harder to value and the financial statements harder to rely on, and both can hurt the seller. A market-based number that repeats every period is what lets an outside reader look at your P&L and believe it.
What a Sustainable Owner Compensation Plan Looks Like
A sustainable, well-structured owner compensation plan begins with paying yourself something that's consistent with the marketplace. In other words, roughly what you would have to pay someone else to do the job you're doing. You can then take quarterly distributions to cover the business's tax impact on your personal finances, and once the business is in a position to support it, allow yourself additional distributions, maybe once or twice a year.
Three components, with a sufficient cash reserve underneath all of it. The regular payment is the anchor. The quarterly distributions keep your personal tax obligation from becoming a cash surprise. The periodic distributions are what's available after the business has been taken care of first.
How to Decide How Much to Pay Yourself
When we meet a client that's just pulling cash out of the business whenever they feel like there's enough there, the first thing we suggest that they do is establish a regular recurring payment to themselves that the business can sustain. They might not nail the amount the first time, and that's fine. Getting the number roughly right and repeating it beats getting it exactly right once, and you can adjust as the business gives you room to. Once the payment is running, your next budget gets built on a real number instead of a guess.
Heath Advisory works with agencies and professional services firms to structure owner compensation the business can sustain, produce financial statements that lenders and buyers can rely on, and give owners a clear read on whether the business is actually profitable. Reach out for a free consultation if you're paying yourself whatever's left over and you'd rather have a plan.
