I wish I could call this rule unique, but it’s not. However, I rarely see a simple mental construct on how profits should or could be allocated over any twelve months.
The 40-30-20-10 Rule™ is also a guiding principle to generate better ideas for sharing and allocating profits. In this brief discussion, I’ll start with the numbers on the outside and finish with the middle two numbers.
The 40-30-20-10 Rule™ Is Easy for Cash-Centric Businesses
While the statement in the section heading is true, let me define the numbers to explain my reasoning:
- 40 – percentage allocated for income taxes
- 30 – percentage retained in the business
- 20 – percentage available for owner distributions
- 10 – percentage available for employees
Try not to get hung up on the numbers. They will never be exact. They are starting points for the only four uses of profits: for taxes, for continued investment in the business, for distribution to owners, and the sharing of profits with employees. On that last point, only a small handful of businesses do this, but I’ve still included the allocation in this simple framework.
Let’s assume your business is a $3 million four-star restaurant. Assuming structural and kitchen upgrades are unnecessary in the foreseeable future, this is about as much of a cash business as possible.
The profit allocations above are easy to divy up whether it’s quarterly, semi-annually, or once a year.
With an accrual-based business with plenty of receivables and inventory, a company’s bottom line in cash may take a couple of months to realize, more if it is a parts supplier in the automotive industry.
This hopefully explains why pulling $100,000 in an owner’s distribution on $1,000,000 in pre-tax profits may seem impossible. That’s because much of the cash may be tied up in receivables and inventory.
I’m trying to prep your mind as you keep reading. While the 40-30-20-10 Rule™ sounds great in writing, applying it can be tricky because we don’t work in a 100% cash system.
Taxes
Early in my consulting career, I encountered a bizarre situation that left an impact on me that I swore would never be a blind spot with future clients.
On my first day on the job with this electrical contractor in Hannibal, Missouri, his CPA emailed that his tax bill would be about $360,000. He hit the roof. He was outraged.
I didn’t dare ask him why the accountant didn’t tell him sooner. I don’t think he was penalized because he made quarterly safe harbor payments. That still didn’t make his newfound knowledge easy to swallow.
From then on, I created a simple template for clients showing their estimated incremental taxes driven by their business profits. I then showed what they had paid to the IRS and their state’s Department of Revenue. This template was updated monthly, showing whether the income taxes were fully funded.
This is the long story of the number 40. The first number in the 40-30-20-10 Rule™ represents the amount that needs to be allocated for income taxes. Your number might be closer to 30%. That’s good because you have more profits for the other three buckets.
By the way, I like these round numbers. They are easy to remember. When I see sizeable profits on a client’s P&L, I can easily do the mental math by subtracting what is not available for investment or owner distributions.
Let’s now move to the number on the far right of the 40-30-20-10 Rule™.
Sharing the Profits
In my practice, I never recommend profit sharing. Most of my clients read my blog posts, so they quickly learn why I’m a fan of employee profit-sharing plans. They typically bring up the topic before I do.
The first question is always, “How much?”
I created the 40-30-20-10™ Rule to help business owners not have to think too hard about this question. The 10% is by process of elimination. Generally, we need around 40% for income taxes. High-growth companies typically need to retain upwards of 30% of their profits. Where does that leave us if the owner can pull out 20% without harming the business’s financial health? 10%.
Remember, 10% is not a hard and fast rule. Your number might be 5%, or 12%. The 10 is merely a starting point or number to get you to start thinking about sharing profits if you have never done this before.
The Middle Numbers, The Sandwich
I’m going to recap the middle numbers again:
- 30 – percentage retained in the business
- 20 – percentage available for owner distributions
These numbers can be flipped for businesses with little or no debt and growing revenues of less than five percent annually. That is, the owner can pull more money from the business. Retaining the other 20% may still be exorbitant.
In cases where the business is growing more than 20% annually, I recommend the business retain from 30 to 60 percent annually until the growth slows down. If your financial executive maintains a rolling financial model, it will show your capital need and if the profit retention is adequate to fund the continued growth.
Similar to the comments above about profit sharing, these round numbers are easy to remember and naturally force us to think about what we can pull from the business or retain in the business. Before I met them, I noticed that many business owners were winging it when it came to pulling money from the business. No thought was put into the decision. The 40-30-20-10 Rule™ gives us a thought process for allocating our profits.
Bonus: Two Precedents for the 40-30-20-10™ Rule
Do precedents exist for the 40-30-20-10 Rule™? Absolutely. This framework is not unique. All I’ve done is rounded the numbers for the only four uses for profit:
- about 40% is allocated for income taxes
- about 30% is allocated for reinvestment in the business
- about 20% can be distributed to the owner(s)
- the remaining 10% can be allocated to employees
By luck, I’ve found one clear example of how one company allocates its profits. In a second case, I’ve found how one company determines what it will share with employees. To learn more, you can listen to my examples: