Cash-Flow Accounting
If you own a small business or work as a contractor, how much do you pay yourself in bonuses or salary? And how much do you put away for taxes? Cash-flow accounting is a system that tells you exactly how much to allocate into three categories.
The percentages may vary as your business grows; how much you put into each category depends on your annual revenue. For now, what you need to know is the three basic categories into which to allocate your earned money (revenue) each month:
Owners Compensation: If you’re an owner of the business and you materially participate in the operation, you will need to pay yourself a wage or salary. If you don’t pay yourself, you’ll likely overspend on operating expenses and make poor financial decisions. And, if you don’t take a “reasonable” salary, the IRS will most likely take a closer look at your business structure. Your “owner’s compensation” will be 20% of total revenue. You might take more money out of the business, not as compensation, but as rent, benefits, or distribution of profit.
Operating Expenses: This is the category to which you will allocate 60% of total revenue for the operation of the business. Expenses include cost of goods sold, labor, rent, office supplies, utilities, advertising, etc. While these might be fixed costs, they also need to be controlled costs. Too often, businesses spend most or all of their revenue on operating expenses to grow the business. The operating expenses should not exceed 60% of total revenue unless you’re a passive owner and do not receive compensation.
Profit Account: This is where your business grows its cash reserves. It is also where the company's owners receive their quarterly bonus as a distribution of profit, which is passive income and, therefore, not subject to self-employment taxes. Your profit account is a savings account connected to your business checking. You funnel 20% of total revenue into this account, and the owners split 50% of what is in that account at the end of every quarter. If there is no profit, you must examine your compensation and operating expenses.
You might be thinking about taxes and how you will pay them. Even if you’re in a higher tax bracket, you should have enough deductions to lower your tax liability. If you don’t, you’re not taking advantage of the tax code or have the wrong business structure. The remaining 50% left in your profit account can be used to pay your tax bill. However, if the profit account balance is not needed, it should be left in the business savings account as a cushion for the unexpected or used as capital.