Recently, a client asked a great question:
“We’ve had a good year and have extra cash in the company bank account. How can we take profits out of the business, or should we set up a bonus structure for the partners?”
It’s an important question, and here’s the approach I recommend.
When You Should Take Profits Out Of Your Agency
Step 1: Prioritize Paying the Owner Regularly
The first thing we need to ensure is that owners are getting paid an adequate wage on a regular basis. Whether you’re structured as an S Corporation or a partnership will dictate how taxes are handled:
- S Corporation Owners: Your payroll already has tax withheld, so it’s accounted for at the time of payment. This makes managing taxes a little simpler.
- Partnership Owners: The payments you take out—whether guaranteed payments or distributions—do not have any taxes withheld. This is a key distinction. So, it’s essential to set aside roughly 40% of your regular payments for federal and state taxes. Important – Check with your CPA to see what your effective tax rate is. For example, if you take out $20,000 per month as a partner, about $8,000 should be set aside for taxes. This ensures that you’re prepared for tax liabilities and won’t face a surprise come tax time.
Step 2: Pay Quarterly Estimated Taxes
After ensuring the owner is regularly paid and taxes are set aside for those payments, the next step is quarterly estimated tax payments. If your tax rate is around 40%, you need to pay taxes not just on your guaranteed payments but also on the profits of the business.
These profits are calculated after the owner’s regular payments. So, if your business is generating extra profits, 40% of those profits should also be set aside for taxes.
I recommend transferring the tax funds to the owners a week or two before the estimated tax payment deadlines so they can make their payments to the IRS and any relevant state agencies.
Step 3: Build a Cash Reserve
Now that we’ve covered paying the owner and setting aside taxes, it’s important to focus on building up a cash reserve—or “war chest.” This reserve is crucial for ensuring the stability of your agency, especially since agency revenue can fluctuate. If a project is delayed or revenue dips, a healthy cash balance helps you weather the storm without stress.
So, What is a Healthy Cash Balance?
Typically, a healthy cash balance is 2-3 months of your regular operating expenses. I find that closer to 3 months often feels like too much cash sitting in the business, while dipping below 2 months starts to cause cash flow pressures.
In most cases, 2 months of operating expenses is the sweet spot for agencies. This allows enough of a cushion to handle revenue swings while keeping the business agile.
I find it usually passes the “gut” test.
A fun exercise is to write down how much cash you feel your agency needs in the bank—to where you would no longer be stressed about cash flow, but holding much more than that would feel like too much.
Then go ahead and calculate what 2 months of operating expenses are. I bet it’s going to be pretty darn close.
Step 4: What Counts as Operating Expenses?
Operating expenses include everything your business pays on a monthly basis, such as:
- Payroll (including the owner’s pay)
- Rent
- Advertising
- Utilities
- Other recurring costs
It’s important to focus on recent figures when calculating these expenses.
If, for example, your payroll has increased in the last 6 months, you should base your cash reserve on the most recent payroll figures, not historical averages.
For partnership owners, make sure your guaranteed payments, along with the 40% set aside for taxes, are included in this calculation.
Step 5: Distribute Excess Profits
Once your agency has built up a war chest of at least 2 months of operating expenses, any extra cash in the bank can be distributed to the owners.
For example, if your monthly expenses are $250,000, you’d want at least $500,000 in the bank. If your current bank balance is $700,000, that means $200,000 is available to be distributed to the partners—tax-free since taxes have already been paid.
Is There a Certain Time of Month or Year To Distribute Your Agency Profits?
Not necessarily, but they never should be more frequent than quarterly. You can also opt for semi-annual or annual.
It’s important to put a cadence around it and not just do it “whenever there is extra cash”.
Taking Out Agency Profits: The Recipe for Success
We hope this has been helpful! This process sets you up for success as an agency owner.
To recap, it starts with prioritizing regular payments to the owner and setting aside taxes along the way to avoid surprises.
The next step is building a healthy cash reserve to protect your agency from the ups and downs of revenue. Once you’ve hit your cash reserve target, any excess cash can be distributed to the owners—fulfilling the ultimate purpose of your agency: generating cash for you, the owner.
This approach ensures your agency stays financially healthy while you, as the owner, can take profits without worrying about unexpected tax bills or cash flow issues.
And the sooner you’re able to take out excess profits, the sooner you’ll experience the satisfaction of knowing your agency is in a strong financial position.
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Until next time!
