Don’t Treat Your Business Like an ATM

 In Articles, Small Business Advisory & Consulting

One of the more challenging conversations I’ve had with some of my Clients – the implications to their Business if they treat their Business like an ATM.

In general, the act of taking money out of your Business, does not reduce the Company’s profitability. This is a huge misconception. Unless there’s a business purpose for doing so, if an Owner, Partner, Proprietor, or Shareholder takes cash out of their Business, it reduces the value or Equity of the Business, not the profitability of the Business.

Profitability is a measure of operating performance. If John (Sole Owner of an LLC) takes a cash withdrawal of $2,000 from his LLC to make a payment for his son’s braces, this is not a deductible business expense. This transaction reduced the value of John’s LLC by $2,000. In addition, If John’s Business is taxed as a disregarded entity (for federal tax purposes) then his pay is NOT a deductible business expense, but if he has employees, their pay is deductible.

As an aside, If John were an Owner of an S-Corporation, he would be required to take a reasonable salary and his salary would be a deductible business expense. S-Corporation Owners (Shareholders) in effect, wear two hats – Owner as well as Employee. Separate from salary, cash or property distributions (in general) are not deductible by the business or taxable to the Owner/Employee. But, exceptions do exist and an S-Corp. Owner/Employee could be the recipient of a negative tax consequence if their distributions exceed their tax basis – a different topic, altogether.

This type of value “destruction” is not an academic consideration, it has real world implications, depending on what Owner’s intentions are – do they intend to aggressively grow their business? Grow it at a more manageable pace? Or, simply keep what they have, trim expenses and make the business attractive to sell?

If you’re planning to grow your Business, you’re almost assuredly going to need credit. Creditors will be looking at the book value of your Business as ONE measure of value when deciding how much to lend and at what rate (that reflects their risk).

Even Businesses with more moderate growth objectives may need Lines of Credit or Credit Cards to manage periods of cash shortfalls.

To compound this confusion, deductible business expenses do (ultimately) get booked as a reduction to Equity (in Retained Earnings).

The Accounting for Business Owner’s pay varies with the type of entity the Owner has – C-Corp., Partnership, S-Corp., Sole Proprietorship all have compliance requirements. In some cases, these requirements are not specifically defined – such as a reasonable salary for S-Corp. Shareholders.

In short, Business Owners need to consider the impact of cash withdrawals on their goals/objectives relative to the compliance requirements (laws) of their specific Business Entity. For Owners that simply treat their Business like an ATM, it could very well hinder their growth targets, financing objectives and create negative tax implications.

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