The Two Ways You Earn Money in a Business
Oct 28, 2024In this episode, Shannon sheds light on the two distinct ways entrepreneurs earn money from their businesses, an essential topic whether you are a solo entrepreneur or part of a multi-member corporation.
Shannon begins by sharing her recent client experiences, where many in partnerships sought to exit or restructure their agreements. This trend underscored the importance of understanding how money is earned and distributed in business structures like corporations and partnerships.
When you start as a sole proprietor or running a single-member LLC, things are relatively straightforward. You keep all the profits, with direct deposits into a separate business bank account, and the withdrawals flow freely for personal and business expenses. There is minimal distinction between you and your business assets.
However, complexity arises with multiple owners. Agreements must be established to determine profit sharing, which can be equal or proportional. Shannon explains that in a corporation, whether an S Corporation or a C Corporation, owners must differentiate between their roles as owners and workers.
As an owner, you receive distributions or draws, known as capital draw, based on your ownership percentage. This method is unrelated to the amount of work you put in. As a worker, however, you should be paid a wage that corresponds to the market rate for your services, like preparing tax returns or conducting CFO calls. This salary reflects the genuine effort and tasks you perform for the business.
Shannon highlights a common issue in multi-owner businesses: partners who are not contributing but still collect profits based on their ownership stakes. These ‘deadweight’ partners can be a significant drain on resources, and if they haven’t been involved for years, they are still entitled to their profit share until they are formally removed from the business.
To avoid conflicts, Shannon emphasizes the need for comprehensive operating agreements. These agreements should detail not just profit distributions but also the consequences if partners cease contributing. Such clear agreements can prevent scenarios where a partner drags down the business while still drawing from the bank account.
Regular strategy meetings among partners are vital. Shannon advises quarterly or even monthly meetings to revisit and reaffirm how and when partners get paid. Engaging a third-party like a fractional CFO or COO can add accountability and ensure compliance with the agreed terms.
Shannon also stresses the importance of consulting with a CPA and a lawyer before setting up any agreements to cover all potential scenarios, including what happens if a partner stops working. Clear legal and financial guidelines can help manage expectations and prevent disputes.
Understanding the different roles and types of payments, from both a paperwork and psychological perspective, is crucial. Shannon recommends thinking of yourself as both "the Owner" and "the Employee" to clearly manage salary (W2) and distribution earnings. This approach can save significant disagreements and heartaches down the line.
What you'll hear in this episode:
05:55 Partnerships drift; inactive partners still profit.
08:50 Understand business roles: separate owner and employee.
11:42 Avoid difficult situations: Plan and understand partners' needs.
If you like this episode, check out:
Productivity Does Not Equal Profitability
The Five Money Metrics You Need
Where Are the Best Places to Look to Find Cost Savings?
Want to learn more so you can earn more?
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The information contained in this podcast is intended for educational purposes only and is not individual tax advice. Please consult a qualified professional before implementing anything you learn.
