Chuck Wilburn was already a veteran Shakey’s Pizza Parlor operator when he watched a new restaurant open across the street from his Redlands, California, store several years ago. The restaurant was good, and the business flourished quickly. But Wilburn wondered how long the good times would last when the owner’s spending habits changed drastically amid that honeymoon period.
“He’s only just opened and he’s already living large,” says Wilburn, who has been in business 25 years. “One day he comes riding in on a new Harley, and then I see him in a leased BMW. The next thing you know, I hear there’s trouble.”
Word on the street revealed the operator wasn’t sending his employee withholdings to the government, plus he was dipping into the business’s surge of cash flow to fund his power toy habit. When suppliers began cutting him off, the restaurant died.
“I’d been in business long enough by that time to know you can’t drain the business of its cash,” Wilburn says. “Heck, I remember the days when I was hoping just to have a really good night so I could cover payroll. You learn to set a lot of money aside and take very little out.”
Tom Kohler, a certified public accountant and owner of Premier Accounting Services in Louisville, Kentucky, says the failed operator’s story is not only too common, his problem likely was tied to a misunderstanding of how best to pay himself. Since most small businesses are structured in such a way that owners don’t receive a salary, many owners mistakenly use the business’s cash flow and profits to pay themselves an owner’s draw without understanding the tax implications.
“The phrase ‘owner’s draw’ sounds simple, but in reality the concept is complex,” says Kohler, who specializes in bookkeeping and tax assistance for restaurant groups. “As the owner, you can draw that money out, but that draw has to be labeled clearly so the IRS can tax it properly. That it’s called the owner’s draw is part of the problem: it’s just too vague.”
Knowing how to classify each draw derives from whether a business is an LLC (which can be taxed either as a partnership or S-Corp), a partnership, an S-Corp or a C-Corp. (For truly detailed advice on business types, seek advice from an attorney, bookkeeper or tax preparer.) That means the owner’s income will be taxed either at a personal tax rate, the business’s tax rate, or as wages if that owner is listed as an employee of the company.
For example, in many S-Corps and LLCs (taxed as S-Corps), draws made on profits are not considered an expense to the company. Such draws are subject to federal and state taxes, though not FICA, Medicare, Medicaid or unemployment.
But in both S-Corps and LLCs (taxed as S-Corps), the owner can simultaneously be an employee and have any draws taxed as wages. Unlike money drawn as an owner, those wages are subject to all federal and state taxes, including FICA, Medicare, Medicaid and unemployment. But those wages also are considered an expense to the company and reconciled differently than draws at the end of the year.
Overall, says Kohler, the tax impact is usually lowest when an owner draws on profits rather than setting himself up to be paid a wage. But how much one draws out can make things tricky.
“Let’s say yours is an S-Corp, and you have $100,000 in your account. You might say, ‘Well, I’ll take it all out as an owner’s draw and avoid paying Social Security and Medicare,’” Kohler began. “Sorry, but no! If you withdraw all your money from an S-Corp as an owner’s draw, the IRS will reclassify all or part of that money as wages, and then you’re taxed differently. That can be a significant amount of money…”
Partnerships, while modestly simpler, are taxed solely on the business’s net income. For
example, if a company’s revenues are $100,000 and its expenses are $20,000, it has a net income of $80,000.
“So even if you draw $50,000 or $70,000, you’re still taxed on $80,000,” Kohler says. “That $80,000 is subject to all taxes except federal and state unemployment; you still pay that 15.2 percent for FICA and Medicare.”
Michael Shepherd founded Michael Angelo’s Pizza as an S-Corp, but later repositioned it as a C-Corp to lower his personal tax burden.
“The difference for me was paying 15 percent tax versus 28 percent tax,” says Shepherd, whose pizzerias are in Kenton and Rushsylvania, Ohio. Based on profits and cash flow throughout the year, Shepherd raises or lowers his draw. “There are times when I choose to pay myself more and be taxed at my pay rate rather than let the company pay a corporate tax rate on that money. You have to watch it closely.”
Watch it closely –– while also looking toward the future, says Robert Langdon, CPA, author of Managing your Business for Profits, and a regular financial speaker at the International Pizza Expo. Too few operators — and especially new ones — take the time to forecast their sales and expenses in order to ensure the business is properly funded.
“Most people, when they start a business, either overestimate sales or underestimate expenses, and sometimes both,” says Langdon. “They’ve got to let the business build up cash before they even think of taking money out of it.”
If a business has operated two or more years, its history will provide a picture of expected expenses. If it is profitable, Langdon says that owner should only then consider drawing some money out of it — and just some, he stresses.
“You don’t want to draw so much out of the business that you have nothing to fall back on when something unexpected happens,” he says. “The goal is to keep cash flow up.”
Steve Coomes is a former Pizza Today editor and freelance writer in Louisville, Kentucky.