The question of owner’s compensation is a hot issue for small businesses paying taxes as either an S-corporation or a C-corporation. When the business files taxes as a corporation, the owner must also be paid as an employee. Not only is the owner the investor, s/he is also an employee. For the purposes of this post, let’s assume the business is filing as an S-corporation.
Creating a compensation plan for your employees is hard enough, what should you consider when deciding how much to pay yourself?
Here are three primary considerations for deciding owner’s compensation for an s-corporation.
1. Payroll Taxes
Has the IRS ever asked you how much you want to pay in taxes?
Of course not, however, with an S-corporation, you can decide for yourself how much self-employment taxes you want to pay.
Earning money through wages is the most taxed way to earn money. Wages are heavily taxed especially up to the social security wage limit. To recap, the employer is responsible for one half of the FICA taxes for every employee. These are payments for social security and Medicare that come from the wages. Between the employer and the employee this amounts to 15.3% (half for each). This is in addition to your income tax. And as an employee of your corporation, you are deciding how much to pay on your salary.
Let’s assume the owner compensation for your practice is $120,000. Of that salary, $9,180 will be paid by the employee in FICA tax and $9,180 will be paid by the employer for the same cause. Before other payroll taxes, a total of $18,360 will be paid just in FICA taxes.
Consider another example.
The owner of a practice pays owner’s compensation of $60,000. Summing both the employer and employee’s FICA tax totals $9,180, a savings of exactly half what was being paid previously. As an S-corporation, the difference in what the owner saves flows through to the personal tax return without paying this 15.3% tax.
That’s a 50% savings!
Can you see why the IRS cares about this?
They know that if all S-corporation owners set their salary at $20,000 (or better yet, they don’t take a salary) regardless of how profitable the business is, payroll taxes from the owners would drop like a rock.
To combat this, the IRS says that compensation must be “reasonable”.
If you are thinking that term seems a little difficult to define, you are correct. What is reasonable in one area of the country or city may not be in a different. Reasonable in one industry is not in another.
There are many methods of establishing reasonable compensation including comparing salaries to other executives, calculating tasks and responsibilities by their respective hourly rate and determining profitability of the business and environment. At the end, of this exercise, there should be clear documentation to why the compensation is reasonable and that should be readily available in the event of an audit.
Assuming compensation is reasonable, the lower the payroll, the lower the payroll tax.
2. Financial Reward
No investor runs a business without the expectation of some financial reward. After all, these aren’t non-profit businesses. There needs to be a profit. Too many service firms are paying their owners too much money and not generating a reasonable return for the business. (There we go again using the term reasonable.)
In valuing companies, a discount rate is used to predict the future cash flows from a business. The riskier the business, the higher the discount rate. The safer, the lower. The size of the company is inversely related to its discount rate, meaning a Dow Component has a higher likelihood of predicting future cash flows than a practice with 20 people. Therefore, the expected profit from your practice should be considered when setting owners’ compensation.
For example, if practice revenue is $1M and owner’s compensation is $200k with $20k in income, that represents a 2% net income margin. By comparison, the business is earning about what a savings account would for the owner!
If the salary were adjusted to $100k in the above example, the profitability jumps to $120k (not considering the savings in payroll taxes). This becomes a 12% return to the owner, a little higher than the long-term average of the S&P 500.
Because of the risk profile of a small company, the business should be generating a higher return than if the owner invested in a stock market index fund. Unfortunately, many companies are managed to make well less than investing in an index fund.
3. Primary Responsibilities
Most business owners aren’t exactly fat cat CEOs of publicly held companies. No private jets, chauffeurs or limos catering to their every need. They know that this is their business and if they can save money it ultimately counts as income that flows into their pocket.
That’s why most of them spend enormous amounts of time performing menial tasks like payroll, accounts payable and bookkeeping. These are low to moderate skill task that are easy to quantify and value. How much time spent bookkeeping? Multiply that time by what a bookkeeper would cost. This process, just like in determining reasonable compensation, can assist in valuing your time.
If the majority of your time is spent on low-value work, adjust your income accordingly and then figure out how to add more value to your company.
The owner of the company also does not need to be the highest paid employee. Many times, even in publicly traded companies, the best brokers or sales people make more than management. The same is true in a privately held company. Just because you are the owner, you don’t need to have the highest wage.
Owners compensation is a challenging topic with many aspects. Payroll taxes, financial reward and primary responsibilities are three core issues to consider when setting salary.