52 Weeks of FOS

Owner Compensation and Reported Company Profitability – Week #45 of The Financial Operating System®

December 8, 2025 by Calvin Wilder in Articles

These weekly notes on The Financial Operating System strive to empower business owners to get better insight into their financial performance so they can make management decisions to move their businesses toward their financial objectives. One major impediment to that is how owner compensation is accounted for. This chapter delves into the significant impact that owner compensation accounting has on reported profitability and the importance of correctly accounting for owner wages to ensure accurate financial reporting and decision-making.

Key Points:

1. The Problem with Misclassified Owner Compensation

  • Many small businesses organized as LLCs or partnerships fail to properly account for owner compensation. This results from applying tax law to financial reporting– a classic apples and oranges situation. Management accounting and tax accounting can be very different.
  • In these cases, owner wages are often classified as distributions of equity rather than operating expenses, which can lead to:
    • Inflated profitability on the income statement.
    • Misleading financial reports that hinder effective decision-making.

2. Why Owner Compensation Matters

  • The work performed by owners is equivalent to that of an employee and has a market value.
  • Properly accounting for owner compensation ensures that:
    • The income statement reflects the true cost of running the business.
    • The reported profitability aligns with the economic reality of the business.

3. Proper Accounting for Owner Compensation

  • For Corporations (S-Corp or C-Corp):
    • Accounting is usually done properly. Owners take a salary that is recorded as a wage expense in the income statement. This is standard accounting practice. 
    • Additional distributions or dividends can be paid out as dividends or distributions on the balance sheet (and not appear on the income statement).
  • For Partnerships and LLCs Taxed as Partnerships:
    • While tax laws classify owner payments as distributions of equity, these should be recorded as an expense on the income statement for management accounting purposes.
    • Owners should take a market-rate salary that is recorded as a wage/draw expense on the income statement. 
    • Additional distributions beyond salary are booked as distributions of equity on the balance sheet.
    • This ensures that the reported profit reflects the salary cost of the owner’s work.

4. Example of Misclassified Owner Compensation

A business with $2,000,000 in revenue and $200,000 in owner wages could report either:

  • Profit of $100,000 if owner wages are recorded as distributions (skewing financial reports and making the owner think the business is profitable when in fact it is not).
  • Loss of $100,000 if owner wages are correctly recorded as an expense (providing a realistic view of actual profitability that needs to be improved).

This distinction can significantly impact strategic decisions, such as hiring, pricing, spending, and investment.

5. Determining Market-Rate Compensation

  • Owners should estimate what they would need to pay someone else to do their job.
  • This market-rate salary should be recorded as an expense on the income statement.
  • Any additional payments to owners can be treated as distributions on the balance sheet.

6. Benefits of Proper Owner Compensation Accounting

  • Accurate financial reporting including all operating expenses of the business
  • Better decision-making based on the real cost structure of the businesses

Takeaway:

Properly accounting for owner compensation is crucial for business owners to understand the true costs and profitability of their businesses. By treating owner wages as a true operating expense, regardless of legal entity structure and tax elections, businesses can achieve an accurate understanding of their profitability and make informed management decisions.

Next Step:

Business owners can self-implement The Financial Operating System. Chapters are available to download at smartbooks.com/resources or you can buy the whole book from Amazon (the marketing firm version or the general business version).

If you would like assistance with implementation or would like to accelerate results for your business, please contact author Cal Wilder at cwilder@smartbooks.com or book a free consultation with our team directly using this calendar link.