The Biggest Accounting Mistake Small Biz Owners Make


Do you run a small business?

Are you self-employed?

If so, there’s a strong chance you’re among the thousands of small business owners who make this critical accounting mistake …

… and thanks to this one simple error, they never realize how strong or weak their business is.

Yikes!

No, it’s not a mistake that will get you in trouble with the IRS … in fact, tax laws are written in a way that promotes this erroneous way of thinking.

As a result, some small business owners spend their lives never realizing they’re committing this glaring error.

Many small business owners — especially solo entrepreneurs — confuse profits with pay.

They fail to calculate profits AFTER paying themselves. They never account for their own time. They think their business is turning a profit – when in fact, it’s operating at a loss.

What do you mean?

Sally is a freelance writer for a handful of newspapers and magazines. She writes celebrity gossip. Last year, from her home office, she pitched — and got! — lucrative assignments from big-name publications like People magazine, TMZ.com and the Los Angeles Times. She brought in $55,000 last year from her writing assignments. When she sat down to do her taxes, she deducted her “business expenses” as follows:

Professional association dues – $72
Conferences – $500
Smartphone  – $1200
Home Internet – $720
Postage – $500
Home office deduction – $2,000
Land-line Telephone – $120
Mileage – $1200
Flights – $1500
Hotels – $1800
Meals – $700
Web domain and hosting – $80
Total Yearly Expenses: $10,392

Sally subtracts this from her income of $55,000, and reasons that her “Freelance journalism” business made a pre-tax profit of $44,608. Right?

Wrong! Sally Didn’t Make a Profit At All!

But $44,608 isn’t the profit that her business made — it’s simply the pre-tax money that was left over in the business to pay herself.

Let’s imagine Sally had an assistant who earned $25,000 a year doing research for Sally’s stories. Sally would deduct that research assistant’s pay as an “expense” before calculating the profits her business made that year, right?

So why wouldn’t she value her own time?

This is where freelancers and other small business owners so often get it wrong — they fail to value their own time in the same way they would value an employee’s time.

How Much Is My Time Worth?

Let’s imagine that Sally were to decide freelancing is no longer the life she wants. She applies for a job. During the interview, HR asks for her salary requirements. Without hesitation, Sally says: “$50,000 a year.”

She’s making a statement that $50,000 per year is what she feels her time is worth — about $25 per hour in a 2,000 working-hour year (40 hours per week x 50 weeks per year).

Why wouldn’t she make that same demand on her own company?

Sally is an employee — the ONLY employee — at her writing business.

So what if Sally were to “pay herself” as though she were her own employee? Then she would realize that she didn’t make a “profit” of $44,608 last year.

In fact, after paying herself $50,000, her freelance writing business actually LOST money, to the tune of $5,392. Her business isn’t in the black (profits); it’s in the red (debts).

How can she pay herself more than she earned?

But if Sally were to put herself on a salary of $50,000 a year, how could she pay herself $5,392 more than her business earned?

Her business would need to borrow money in order to pay it’s one employee, Sally.

If Sally doesn’t want to go to a bank (they’re not keen on lending to freelance writers), she’ll have to borrow money from herself in order to pay herself.

Borrow Money from Yourself?

Borrowing money from yourself, in order to pay yourself, is a strange mental hurdle.

“What’s the point?,” you might ask. “It ultimately comes to me.”

Yes. But you need to keep your business finances separate from your personal finances. You deserve to be earning a salary. Your business needs to pay you.

And your business also doesn’t have the money. It needs a lender or an investor. Enter: You.

When you pay yourself, you separate Owner You from Worker You.

On one hand, you feel great — look, you’re earning a monthly salary! On the other hand, your business feels broke — it’s constantly in the red and can’t even keep up with paying its employees (you).

Borrowing money from yourself, in order to pay yourself, is the best way to value your time. You’ll keep the company’s financials in clear perspective.

One final note: Charge your business a reasonable interest rate, like 5 percent, on the loan that you issue. After all, you deserve to be compensated for your risk.

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11 Responses to “The Biggest Accounting Mistake Small Biz Owners Make”

  1. kh
    18. Mar, 2011 at 9:22 pm #

    Well, two things: If someone is a sole-proprietor or independent contractor, the IRS says that profit after expenses (net profit) *IS* the owner’s income/salary. So in a sense, it is profit – from an IRS standpoint.

    Which brings us to the most important part: The biggest mistake new small biz owners make is not (IMO) equating income with profit, it’s forgetting about taxes.

    If Sally grossed $44,608 from her business, and is a sole proprietor, then she has to pay taxes and self-employment taxes.

    So let’s say Sally is single and has no children. She will have to pay:

    Federal Income tax: $7,338
    Social Security tax (12.4%):$5,531.39
    Medicare tax (2.9%): $1,293.63
    Total taxes paid: $14,163.02

    So Sally’s real profit/income (going by the IRS definition) is actually only $30,44.98.

    And that’s not counting any state, city, or county taxes or fees that she has to pay to be a proper, legal, registered business.

    • AffordAnything.org
      18. Mar, 2011 at 10:30 pm #

      @kh: Many small biz owners forget about taxes, especially Social Security + Medicare, which in 2011 is 13.3% combined (down from the 15.3% you quoted, which was the rate in 2010.)

      The big-picture lesson in this posting is that small biz owners forget to ask themselves the question: “what is my time worth?,” and therefore judge the success of their enterprise without valuing their own time.

  2. Barb Friedberg
    27. Mar, 2011 at 3:24 pm #

    awesome article. never thought about it this way. we’ve had schedule c income for years, and never looked at profit this way! brilliant.

  3. Eric Novinson
    08. Jun, 2011 at 1:54 am #

    This concept is known as economic profit, and it can be negative even if your accounting profit is positive, as you explained. Basically you subtract the income from your next best opportunity to calculate it.

  4. Bryson G. Baylor
    10. Nov, 2011 at 7:44 pm #

    Great post. I never thought about categorizing profit in this manner.

  5. Linda Mcmahon
    09. Jan, 2012 at 3:18 am #

    We should always save for the rainy days because we’ll never know when we face crisis at least we have something to hold on to.

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