Besides having a well-structured profit and loss statement, you need to know how to read it. Even if you are a cash-based business (which you probably are and do not account on an accrual basis), not all cash is captured in your profit and loss. One of the major errors in optometry ownership sounds something like this (see if you find yourself in this story):
“I made $300,000 bottom line last year.”
“Wow! That is great. So you must have a pretty fat bank account.”
“Well, actually, I have $135,000 in my bank account and it is January. Where is the rest of my profit?”
My profit and loss statement would look significantly better if I had a nickel for every conversation I have had like this with owners. My data suggests almost 50% of the time. What is happening here? Let’s break it down.
It all starts with the way you compensate yourself. For about 50% of the optometrists I work with, they compensate themselves through dividends only. No w-2 salary. It sounds very clever, but I cannot understand why any accountant would recommend this strategy.
So last year, you “took home” $160,000. That is the business paid you this amount. When we look on your profit and loss statement, I cannot find this $160,000. Why? What are the implications?
What has happened is that you are paying yourself a dividend – income resulting from an investment (your practice). As the owner, you are entitled to the profits generated by your business and these dividends are taxed at a much lower rate than a w-2 salary. Sounds like a good idea. Consider the rest of the story.
Because these are profits, they are not considered an expense (salaries are an expense). So, the $160,000 you took home last year does not show up on your profit and loss statement, but instead on your balance sheet. Several consequences result.
- You’ve paid no social security tax. You are about to be in for a big surprise when you turn 65. You will either have no income or a very low income and therefore little to no social security.
- You’ve failed accounting 101 which says that any expense generated in creating revenue has to be recognized. In this case, you recognized the revenue created by the owner (as a doctor) but you didn’t recognize the expense. That’s just bad accounting and it leads to the next consequence.
- Your profit and loss statement is not truthful and is telling you made $300,000 instead of $140,000. This leads you to believe that the practice is much healthier than it is and your expectations on your sale price are going to miss your offer significantly.
- While I am not a tax attorney, I would be concerned about making this income and not paying income taxes and state taxes on them. Besides the social security issue mentioned previously, this approach to your income may set up a significant liability with you and your state (who is being deprived of tax revenue).
Accountants who I trust often recommend that you take a ‘reasonable’ w-2 salary for yourself. Reasonable has no hard figure, but I believe the test is ‘what people in your position are paid’. The rest can confidently be paid in dividends. This approach shows a truer accounting of your practice and will be inline with buyers’ calculations when you get to that point.