Maximizing Profits: Key Strategies For Owner Compensation Optimization

In the world of entrepreneurship, the pursuit of profit is the driving force behind every business venture. Contrary to what some new entrepreneurs may think, it is important for business owners to pay themselves a salary when their businesses are profitable.

Erica Martinez, MBA, MST and CEO of Paragon Accountants, a firm helping people build generational wealth, sheds light on the intricacies of owner compensation, providing invaluable insights into maximizing profits through strategic payment methods.

Let’s look at the various approaches to owner compensation, weighing the pros and cons of salaries, distributions, draws, and dividends.

The Profit Paradigm

It’s critical to understand a fundamental principle: the distinction between a hobby and a business is profit. While profitability might take time to materialize, delaying the process of paying oneself can jeopardize the sustainability of the business. Many entrepreneurs embark on their ventures to escape the conventional 9-to-5 routine, only to find themselves working longer hours for less pay. “The key is to view oneself as a legitimate business expense from the outset and to understand the nuances of paying oneself,” says Martinez.

Three Ways To Pay Yourself

She emphasizes the importance of maximizing profits through strategic payment methods and outlines three primary methods for owners to compensate themselves: salary, distribution and draw, and dividend distribution for C-Corps.

Salary

One option is for business owners to pay themselves a salary, a fixed amount paid at regular intervals through traditional payroll systems, resembling the compensation structure of a W-2 employee.

When receiving compensation through a salary, it is a structured arrangement where the income is subject to ordinary income taxes, ensuring compliance with standard tax regulations. Additionally, self-employment taxes, which encompass contributions to social security and medicare, are withheld at the time of payment, mirroring the payroll process of traditional W-2 employees.

“A benefit of taking a salary is that you pay your taxes as you go, which makes budgeting for taxes within your business easier. It’s a fixed income, which can help with personal budgeting,” says Martinez.

This compensation method is particularly common among shareholders of S-Corporations, where owners receive a salary as part of their compensation structure. The choice of salary as a compensation strategy is often driven by the desire for a consistent and predictable income stream, allowing for both personal and business budgeting. However there can be some downsides such as a potentially higher tax rates since both ordinary income taxes and self-employment taxes would apply.

Distribution And Draw

A distribution typically refers to a payment made to the owner of a business, and it is more commonly associated with entities like Limited Liability Companies (LLC). Whereas a draw is often used to describe a withdrawal of funds by the owner of a sole proprietorship or a single-member LLC disregarded entity, where the owner has a more direct and personal connection to the business’s finances.

While the terms are mostly interchangeable, there are subtle distinctions. A draw is commonly associated with sole proprietorships, while a distribution is what an LLC active manager receives.

“Opting for a distribution or draw structure provides flexibility for business owners to access funds as needed. It’s crucial to be mindful of the tax implications involved, including ordinary income tax and potential self-employment taxes during personal tax filing. Owners utilizing these structures, commonly found in sole proprietorships, single-member LLCs, and partnerships, should work closely with tax professionals to ensure compliance and consider making quarterly payments to manage tax obligations effectively,” advises Martinez.

Dividend Distribution: Unique To C-Corps

C-Corp shareholders can receive an additional form of compensation through dividend distributions – which refers to the payment of profits by a corporation to its shareholders.

Dividends are a distribution of a portion of the company’s earnings, typically in the form of cash or additional shares of stock, to its shareholders. In the context of C-Corporations, which are separate legal entities from their owners, dividend distributions are one way for shareholders to receive a share of the company’s profits.

“While venturing into the realm of C-Corporations, consider the unique avenue of dividend distributions. This form of compensation not only offers potential tax savings by bypassing self-employment taxes but also provides a tax-efficient way for passive shareholders to enjoy the fruits of the company’s success. However, it’s crucial to navigate the regulatory landscape and seek professional guidance to ensure compliance and make informed decisions regarding dividend distributions,” says Martinez.

Determining The Right Amount

Having established the ways to pay oneself, the next crucial step is determining the appropriate amount.

The initial and critical step in calculating how much to pay yourself is to determine your company’s monthly net income – which is what’s left after you subtract your business expenses from your gross revenue.

Martinez advises entrepreneurs to calculate not only their own compensation but also that of any employees. Strategic planning in this regard ensures financial efficiency and aligns with the broader goal of maximizing profits. Navigating the complexities of owner compensation requires a nuanced understanding of the available methods. It’s key for entrepreneurs to optimize compensation structures because it ultimately contributes to the financial success and sustainability of their ventures.