Part 1 | Expenses
As we talked about in the earlier module on P&L reports, you need to know your expenses to be able to figure out just how much profit you make. There are two main ways to increase profits: make more revenue or cut down expenses. Just making more money is definitely more fun, but sometimes you do need to lower expenses. Figuring out where and how to do that could make a big difference.
It’s really important that you keep your personal and business expenses separate, including having a separate account and cards for your business, as we mentioned in Module 1. If you mix these up, it will make much more work for you later when you have to separate these for your taxes. If you’re ever not sure whether an expense counts as business related, err on the side of caution. Making mistakes here increases the risk that you’ll be audited unnecessarily, which is a tricky problem you should avoid if you can.
Types of Expenses
The money that comes into your business can be used for a variety of expenses:
- Distributions: Money you pay to yourself without taking a paycheck.
- Business expenses: Money you spend to run your business, including payroll, business materials, and your own paycheck, if you draw one.
- Investment: Profit that you invest directly back into your business to grow it.
- Taxes: Fees that the government legally requires you to pay.
Distributions vs. Salaries
We want to distinguish between a salary and a distribution, because they are taxed differently. When you set up your business as an S corporation, as we mentioned in Module 1, you need to come up with a reasonable salary for yourself and write yourself a paycheck. This is calculated as one of your business expenses, not as a distribution (profit). Make sure you check with your attorney and accountant to ensure that you choose an amount that’s both reasonable and acceptable to the IRS.
All the profit in your business and any money you take out over and above your salary is classed and taxed as a distribution. This is why it’s very important to keep accurate books and not try to rely only on what you actually take out of the business. What you withdraw from your account is pretty much irrelevant. The IRS doesn’t look at that; it only looks at the profit you have made and taxes it, whether you spend it or not. This also means that the money you borrow or take out and spend to create debt will not be considered income. You are only taxed on the profit you make.
In the beginning of your business, you will want to be spending the money from your revenue on growing your business and not on your salary or taking out in profit. Once you have enough revenue to exceed the amount you need to spend on marketing, you will start paying yourself a salary. This salary will ideally be run though a payroll service so the proper amount of taxes will be withheld. Your salary is an expense in your business- you will get the money in cash and it will count as income, but don’t confuse it with profit. Think of your salary as what you get paid for working in your business and the profit is what you get paid for being the CEO and working on your business.
Note: Do not take any profit out of your business until you are paying yourself a market based wage. If you pay yourself too little in salary, you will end up with a distorted view of your actual profit.
The more profitable you are, the more you will pay in taxes. How much you pay, exactly, changes depending on how you do things.
Your salary is taxed several ways:
- Regular income tax: This varies depending on your tax bracket.
- Social Security tax: 6.2% as an employee; another 6.2% as an employer.
- Medicare tax: 1.4%.
If you keep running your business as a sole proprietorship, you pay this tax on your total profit instead of just on your salary. For distributions, you only pay income tax, and it isn’t subject to Social Security or Medicare taxes. If you make your S corporation selection in time to benefit from it for the entire year, this can save you thousands of dollars. Again, make sure your accountant and attorney know that you want to do this early. We’ll talk about taxes in more detail in a later module.
Investments vs. Business Expenses
On your regular P&L report, all of your expenses look and are treated the same way, but it’s very important that you look at them differently yourself, as a business owner. Some of your expenses will actually be investments. Others will be necessary business expenses. And, sometimes, your expenses will be simple wastes of money. The more you evaluate and question each of these, the easier it will be for you to remain profitable.
An investment is money you make and then put back into your business. More simply, this is when you spend money to produce more money. Any money you spend on marketing or hiring people, for example, has the potential to be an investment. It also has the potential to be a waste if you aren’t tracking the return on that investment. You want to make sure you are measuring these carefully so that you know how much money each dollar you spend is creating for you.
Now, let’s talk about business expenses. Having too many business expenses can burn up your ability to invest in and grow your business. Business expenses are things you spend money on for your business that don’t make you money directly. You want to be very careful with all your expenses in the early days of your company, so that you can fund growth. Go through each of your expenses individually and make sure that they are useful and necessary. Then, calculate their costs against any possible investments you could make with the money you’re spending.
When you are thinking about hiring contractors or other help, always evaluate the amount of money they can make from it in actual dollars. To do this, calculate how much you can make per hour by doing the job you are hiring them to do, and ensure that the difference between their pay and yours is significant enough to warrant the hire. We often recommend you hire someone when you find you have more money than time.
These three important questions can help you figure out if any given expense is worth it:
- Why is it necessary?
- How does it help me grow faster or earn more profit?
- Could this money be better used in an investment?
Once you find an answer for each of these questions, you’ll have a much better idea of what’s actually making you money and what’s wasting it.
Writing Off Expenses
There are some very specific rules about what you are and are not allowed to write off as a business expense. Check with your accountant often so that they can help you understand which expenses qualify and confirm anything you’re not sure about. Generally though, it’s a good idea to be conservative about this.
Phones, computers, and home offices are common expenses that are usually safe to write off, as long as you use them for work. As we mentioned above, paying yourself counts as a business expense through payroll. Some people like to count trips as expenses, but you need to be careful about this, as you’ll have to prove that you had legitimate business activity on your trip. Clothes usually can’t be counted unless they’re uniforms for your business or something you’re only buying to wear once for work and never again. Your accountant can help with the details here, so bear that in mind.
If you have incurred debt for your business, the interest you pay on that debt is an expense you can write off against your revenue. The principal paid to the debt is not considered an expense but rather a reduction of liability on your balance sheet. Make sure they are allocated appropriately. How you pay off your debt is completely up to you, but we believe you should pay off your debt as soon as you have grown enough to have more money than time. We would rather invest our money that pay it in interest.