Forget dividends, it’s a trap!

This is what I told John, a client of mine.

John is a lawyer and asked me to review his financial statements. While I was reviewing the income statements, I noticed that the total salary for the 12-month period was $45K.

I looked in more detail on his corporation QuickBooks Online (QBO) file and notice his salary was at $22K.

I looked at John and said, you made less than your receptionist?!

His response was Moe, I’m growing the company.

I said totally wrong but explain your rational.

He said, I don’t take high salary so I keep more money in the corporation and then I can use the money to grow my company.

We looked at QBO again this time on the balance sheet. Total cash in the company was $5K. So I said your rational makes sense, but it’s wrong since you haven’t saved any money.

I told him, look, you are a great lawyer, and your salary would have been close to $200K if you worked an employee for any law offices.

He further explained that his true rationale was to offer his services cheaper so that he can expand his client base and eventually be more profitable.

I said so how about your own income? With $22K can you live?

He said oh that is easy, I’ll take dividends.

I said that is B.S., there is no income, cash or retained earnings.

Unfortunately, this is a trend with other small businesses, even I had this rational when I started. We all assume that offering cheaper services would get us more leads.

Basically, becoming cheap, becomes our marketing strategy.

So I said John, being cheap and cheapest will makes you go bankrupt since that is how people will judge your service and you may win the race of becoming the lowest price.

My advice to my clients is to keep a few things in mind.

Find your company’s hourly charges.

You play 2 roles in your business; one is the owner and the other one is the worker/operator.

The worker/operator should be payroll and get paid for the hours that he is doing the work which is at par with industry or even higher if you think you are an experienced person.

For example, for John at $200K per year salary, his hourly rate should be $200,000 divided by 12 months equals ~ 16,666 per month. $16,666 divided by 150 hours per month is $111.

So John the business owner – let’s call him John Inc. – should charge his clients enough hourly rate that John the employee will receive $111 per hour.

John the employee MUST be paid salary regardless of John Inc. strategies. This is the key.

The next part we want is for John Inc. to be profitable – we want him to have at least 25 per cent net income.

So we reverse engineer this part. We need to calculate admin and office expenses and come up with a ratio. In this case, let’s say the magic ratio is 40 per cent.

We know that he needs to pay $111 per hour to the employee and has also 40 per cent other costs. So revenues less 40 per cent of revenues minus $111 equals 25 per cent of revenues.

Thirty-five per cent of Revenue equals $111. This means the hourly rate to charge a client should be at least $111 divided by 0.35, which equals $317.

In our case, John was probably charging clients at $150 per hour, hence after paying the office and himself he had almost nothing left.

Fast forward to our case (by the way John is not an actual name, but this is a true case only the name is changed to protect the innocent).

As I was saying, we put John on payroll, we use Wagepoint for payroll.

Wagepoint, pays the employee through direct deposit and pays CRA the source deductions on time, files ROE and prepared T4s and records the journal entries in QBO.

It also can be set to auto pilot, i.e. if you are paying someone $6000 per month, the software can do this each month without you even logging in and asking it.

This is an amazing tool that you should have in your arsenal.