The final step in our initial view of business is considering ownership matters. Your business needs capital to operate. It gets this through contributions. We will also consider how you get benefit from your business due to your ownership.
Contributions to your business
Aside from running a not for profit, your business needs to make money to survive. It is important for your business to exist more than just to make a profit. We cover that here. This said, it remains important that your business return more to you than simply putting your money in the bank. Otherwise, why not put your money in the bank – it’s nearly risk free. Business is not risk free. Because of this, your business should return to you more than a bank account to reflect that there is risk being in business.
Keep track of contributions made to your business. Apart from tax reporting, it helps you to understand the rate of return of your business. You do this by using a contribution account in your accounting system. Think of a bank account. If you make a deposit, then the bank account balance goes up in your favor. This reflects the payment (contribution) you made to the account. The same goes for contributions to your business
If you operate your business as a sole trader, you would call your business contribution account as “owner’s contributions”. If, for example, you opened a business bank account and deposited $10,000, you have just made a $10,000 owner’s contribution to the business. Lets say 12 months later, you deposited a further $5,000. Your owner’s contributions are now $15,000. It is important to realize that the bank account balance will change for other reasons – receiving revenue payments, paying people, buying business product – so the value of owner’s contributions and the bank account balance are unlikely to be equal. Owner’s contribution only goes down if you make a deliberate withdraw of capital funds back to you from your business.
Other business structures
Contributions are more formal when using other business structures. If, for example, you (and perhaps others) form a company. The price you pay for your shares is your contribution. In case of a company, the accounting system account would be called “contributed capital” or “issued capital”.
Most operating expenses in your business will be tax deductible. Most private expenses are not deductible. It can be tempting to run some of your private expenses through your business as a benefit of ownership; however, you should resist this temptation.
- you’ll find it harder to understand the performance of your business. Business performance will look worse than what it actually is
- if you are only claiming genuine business expenses at tax time, it will be harder. You’ll need to understand clearly what are private expenses. Given if, you run private expenses through your business, you’ll likely rather want to hide these private expenses rather than making them clear!
- if you claim all expenses, you’ll be breaking the law. If then, tax authorities see any hint that private expenses are being claimed – expect them to challenge every claim you make. You’ll also likely face penalties
- it’s very complicated to account for any private expenses in the business. They are like a dividend, but only paid to a preferred shareholders. Dividends are normally paid to all shareholders equally on a per share basis. Putting private expenses through a business may risk your relationship with your business partners
Getting money out of your business
So, how do you get benefit of your business ownership? The five principle methods are 1) salaries to business owners, 2) owner’s drawings, 3) loans, 3) dividends and 4) capital returns.
Business owner salaries
If you work in your business, your business should be able to pay you. Consider if someone else works in your business, you’ll likely need to pay them – same goes for you. If your business is new, it is understandable that funds are not available to pay you.
A key point to consider is that real business profit exists only after you have paid yourself a commercial salary.
If your business is small, you’re a sole trader and only you work in it, there may be little point in paying yourself a salary. You may not even be permitted to pay yourself in some jurisdictions, . You could, instead, put aside a fixed owner’s drawing each month that is equivalent of a salary. See below for more detail about owner’s drawings.
Short term benefits paid to owners from a business are owner’s drawings. An example is the owner’s equivalent of a salary (see above). Any private expenses paid in a sole trader business are properly represented as owner’s drawings, rather than as business expenses.
Think of owner’s drawings as a short term loan from the business. They are less formal than a loan and don’t require interest repayments. If you never intend to repay an owner’s drawing, it may become:
- a payment of business profit (a dividend). The owner’s drawing was then essentially a prepayment
- a capital return (see below). This would apply if owner’s drawings exceeded business profits, or there was no business profit
Payments made to owners out of business profit are dividends. Dividends are paid per share on an equal basis, in the case of companies.
If not all profits are paid to owners, then this leftover balance becomes retained earnings. Most businesses need some level of retained earnings to fund growth.
The final key method of return to owners is capital returns. If the business does not need all of the contributed capital to operate, it can return some to owners. These payments are generally tax free. This is because they are simply a repayment of money initially put into the business. Tax authorities may require careful accounting. Your contributed capital account cannot be “topped” up by any business profits.
As owners, we have a financial relationship with our business. This relationship can involve moving money into the business. It can also involve money or benefits being received from the business. Key elements include:
- contributions: money invested into the business as capital
- the business paying private expenses – although this can cause you problems with other owners and tax authorities. Best avoided
- receiving a salary as a business owner
- taking owner’s drawings from a sole trader business
- receiving dividends