Successful entrepreneurs have a laser focus on their businesses—that’s a big part of what makes them a success. But as your business grows, it becomes critically important to widen the focus to your personal finances so you take the right steps to fund current expenses and properly plan for the future.
“In my experience, most entrepreneurs have great instincts, exceptional resolve and business vision, but they rarely have a well-thought-out personal wealth management plan,” said Nicholas Murphy, a first vice president and financial advisor with RBC Wealth Management in Raleigh, N.C. “It’s almost like an attorney not having a will: They’re so focused on their business plan that they forget to develop a personal wealth plan.”
Entrepreneurs typically take a team approach to their business and get advice from other professionals, but they don’t always develop that team for their personal needs, said Thomas Six, a wealth strategies consultant with RBC Wealth Management in San Francisco, Calif.
That team should include “a qualified accountant, a lawyer, a tax professional and a personal financial advisor,” said William Freeman Jr., a business consultant with the Maryland Small Business Development Center in Baltimore, Md.
When your business is booming, it’s time to determine the optimal strategy for paying yourself and establishing long-term wealth for you and your family.
Legal structures affect payment plans
Many businesses start out as a sole proprietorship and advance to a partnership and sometimes to an S corporation or a C corporation. How you pay yourself depends on the structure of your business and has legal and tax implications, too.
Sole proprietorship: All the assets and liabilities belong to you when you’re a sole proprietor, so instead of a salary you pay yourself with an “owner’s draw,” said Six.
“You don’t pay payroll taxes for Social Security and Medicare on your draw, but as a sole proprietor you pay both income tax and self-employment tax on that income,” he said.
Murphy said many entrepreneurs opt for an LLC structure for their business to separate their personal assets from the business assets for protection from creditors or in case of a lawsuit. All business owners should be careful to keep separate business and personal funds for accounting purposes, according to Six.
Partnership: When you own your business with a partner, you and your partner can determine whether to take your income as a draw or as a “guaranteed payment,” said Six.
A guaranteed payment is an option when you have an LLC. Although you’ll pay income taxes on this payment, the expense is a line item reducing your corporation’s annual tax liability. “You’ll pay taxes one way or the other: it’s just a question of which way has the most advantages for your individual circumstances,” said Six.
S corporations and C corporations: Once your business has been incorporated, you can take a salary and opt to pay yourself a bonus, said Freeman.
Another option, said Six, is to take a dividend distribution, which is similar to a draw and can be used as a strategy to manage personal taxes because it won’t be taxed if it is a return of capital to the shareholder.
Paying yourself with a shareholder loan is also a possibility, but it must be repaid with a specific interest rate and be repaid on time, warned Freeman, otherwise it could trigger a tax complication.
“A wealth advisor can talk to you about when to take out money from your business and how much to take out, but it’s critical to have a tax attorney to consult about the best way to transfer money from your business for personal income and wealth building,” said Six.
Retirement planning challenges for entrepreneurs
In addition to determining how to pay yourself now, it’s essential to plan for the future. “You need to decide how much you want to grow your business and whether you want to keep it as a family business and even bring in other family members,” said Six.
He recommends setting up a retirement fund even if you’re a sole proprietor and then establishing a 401(k) or a profit-sharing system as you grow.
“There are pros and cons to every plan, so you should sit down with an attorney and estate planner to determine the best way to establish your retirement savings,” said Six.
Retirement saving for entrepreneurs often includes deciding whether you’d eventually like to sell your business. “If your business is highly successful you need to start thinking about your exit strategy,” said Freeman. “You may want to reinvest more profits now and pay yourself less so you have a bigger payout if you plan to sell the business.”
Consult with your advisors when strategizing about a future sale. Murphy talked to one business owner who planned to sell his business and said he would consult a financial advisor only after the sale was complete, which wasn’t an ideal move in hindsight.
“When he came to me later and we talked about the next chapter of his life he told me he wanted to establish a charitable foundation,” said Murphy. “If he had come to me before the business was sold we could have funded the charity with stock from the business.”
Diversification is essential
Although investors understand the importance of diversification, it can be difficult for entrepreneurs to invest in someone else’s business, said Murphy.
“I often find that business owners want to keep investing in their own business rather than take money out,” said Murphy. “They’ll tell me, ‘Why should I invest in something that has a 6 percent return when I’m getting a 20 percent return from my business?’ I explain it this way: ‘You would never bet your entire financial world on one single stock, but as a business owner without other investments, that’s what you’re doing.’”
Murphy said a common attribute among highly successful people is they assume they will always be successful. Although that optimism is essential for entrepreneurs, it can be a blind spot for your personal finances.
“If you’re not funneling money from your business onto your personal balance sheet, you’re not protecting yourself from the chance that your business may become obsolete,” said Murphy.
Although a financial advisor cannot substitute for a business lawyer, an estate planner and a tax advisor, Murphy said a personal wealth planner can orchestrate your team to perform around your life goals.
“A common theme I see among most business owners is that they lack liquidity,” said Murphy. “Many times their sole asset is the business and its assets. Here’s the problem with that: If you don’t develop a clearly defined plan of building more liquid marketable assets, you are a complete hostage to your business cycle.”
“Pay yourself first” is the mantra for establishing a sensible savings pattern for everyone and it should be the motto for every business owner, too.