Don’t Treat Your Business Like an ATM
One of the more challenging conversations I’ve had with some of my Clients concerns the implications to their business if they treat their Business like an ATM.
Aside from taking a reasonable salary (a requirement for S-Corporation Owners/Shareholders), the act of taking money out of your business does not reduce the Company’s profitability. This continues to be a misconception. The act of taking money out of your business 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 taxed as a Sole Proprietorship) 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 reduces the value of John’s LLC by $2,000. John’s business is taxed as a disregarded entity (for federal tax purposes) so, any withdrawals that he makes for his pay and personal expenses is NOT a deductible business expense, but if he has employees, their pay is deductible.
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 the Owner’s intentions – do the Owner(s) 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 a would-be buyer?
If you’re planning to grow your business, you’re almost assuredly going to need some form of 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 interest rate (that reflects their risk). Large equity withdrawals (or inconsistent withdrawals) reduce the book value of the business and may create an (unfavorable) impression for would-be creditors as to the overall riskiness of granting a loan.
Even businesses with more moderate growth objectives may need Lines of Credit or Credit Cards to manage periods of cash shortfalls, especially for businesses with seasonal changes in their sales.
Deductible business expenses do (ultimately) get booked as a reduction to Equity through reduced Net Income that ultimately gets reflected in Retained Earnings. However, business expenses (that are necessary and reasonable) will not get the same level of scrutiny that cash withdrawals will. Creditors want to know two things – that a debtor 1. can and, 2. will make payments against their obligations. Cash withdrawals (above what the Owner has budgeted for their pay and personal expenses) reduce the ability of the debtor business to pay it’s obligations.
The Accounting for Business Owner’s pay varies with the type of entity the Owner has – C-Corporations, Partnerships, S-Corp’s., Sole Proprietorships all have compliance requirements. Creating added complexity, some of these requirements are not specifically defined – such as a reasonable salary for S-Corp. Shareholders. How much is a reasonable salary? It depends on a number of factors – the size of the business, the region in which the business operates, and the duties performed by the Owner/Shareholder, just to name a few.
In short, Business Owners need to consider the impact of cash withdrawals on their goals and objectives relative to the compliance requirements (laws) of their specific Business Entity. For Owners that treat their business like an ATM, it could very well hinder the businesses growth targets, increase financing costs and also cause negative tax implications, personally, for the Owner.