Q: Is it better to have a higher or lower owner payout rate?
A: A quick answer to your question is that “lower is better” because the company’s cash flow and cash position is better preserved. A more well thought answer is that distributions should be adequate to fulfill their purpose. Distributions are inescapable for tax “pass-through” entities like Subchapter S Corporations, Partnerships, Limited Liability Companies, and Proprietorships. Owners of these entities are personally responsible for paying federal and state income taxes on business earnings. Distributions are, in turn, the primary vehicle by which cash is made available to owners to pay the taxes due to avoid additional tax impact or eroding the owner’s personal financial resources.
The company must be sure to distribute enough to pay the tax bill since none of the cash flow associated with the business’ earnings routinely flows to the owners. Even so, since distributions are tax-free to the receiving owners, there is always a motivation to make distributions exceeding the amount needed to cover the tax payment due. As a rule, excess distributions should be avoided to reduce the consequence of distressing business cash flow or triggering an IRS review.
The IRS is always interested in this issue since a switch from salaries to distributions minimizes tax revenues, social security, and Medicare payments to the federal government for pass-through business owners. In the case of a Partnership or LLC, it is more difficult to identify excessive distributions since partners’ salaries are not tax deductible for these business organizations. Tax deductible compensation for these individuals comes from distributions or guaranteed payments.
Course overview: Ratios and Messages about Profitability and Cash Flow