Paying Yourself As An Owner
I've worked at and with a few companies that ranged from sub S corporations, to LLCs, to full fledged Corporations. In each case there was less than 20 employees, and in each case the owner had no idea how to go about setting what they got paid from the company, and how.
There are two common pieces of advice out there that have a hint of truth, but tend to be misleading at best, devastating at worst.
- There are tax advantages to taking as much as possible from distributions, so take an extremely low salary
- Taking too much in salary will lower your net income and make your company's income statement look bad.
Neither of these are helping anyone.
An owner should take a market salary for his or her replacement for 3 main reasons. I'll cover them briefly here.
Understand the Business
Without a market salary for yourself, recorded on the books, you will get a false, and inflated sense of how well the business is doing. You should always view your business as someone who is looking to buy it and have it run. This will help your perspective on a number of decisions, including your salary.
Let's say you are taking in $30,000 USD per year, and the income statement shows $100,000 profit at the end of the year. You feel good since your business is spitting out a 100k per year and valued at 4x makes your operation worth almost 1/2 a million!
However, if someone were to buy your business, they would have to hire someone to run it, in the same manner you are, in order to continue to receive those cash flows and profits. Let's say they need to hire a foreman, manager or CEO at $80,000 in order to keep the business running with you gone. That means that (leaving all in costs and additional payroll fees aside) your profit post acquisition would only be $50,000.
This is half of the cash flow, and thus half of the valuation!
Without market salaries, you will not completely understand the numbers in your business.
Going further, how will you know if you are making a profit that is indicative of a healthy or sick business in your industry? If your profits are inflated, your margins will be inflated, and thus you may think you are doing better than you thought.
It is important to run the business as if you are running a self sufficient, cash flow producing, asset.
The next reason is scalability. We now move from conceptual, to causing some real problems.
I first saw this with a landscaping company a few years ago.
The owner was giving himself a $20,000 salary, and then taking money out as a distribution when he needed additional cash for personal bills. Two years prior he had won some high margin jobs and made enough to cover all of his fixed expenses, payroll, and had extra cash left over.
However, as the business had started to grow, he had extra time, and so underbid new jobs to guarantee winning them. He used all his costs involved in running the business to do his quotes and then added a reasonable margin for the industry.
Regardless, two years later he was much larger, with higher revenue, and he had no cash to hire more people, pay his bills, or expand.
How did I get in a worse position by growing?
The answer was simple, he quoted based on his low salary. This means his margins were overstated and he was actually making far less on each job. So when he needed to hire another foreman to help manage the growing operation; there was not only no cash to hire, but not enough enough margin to pay himself.
I see this occur in two main areas, inventory and salary.
You have extra capacity in your warehouse, or extra margin in your cash flow. You underbid or undersell to grow, but by not accounting for the additional space or salaries you will eventually need, you end up cash strapped at the point you need it most.
Avoid A Shutdown
The last reason to include a market salary is to avoid a complete business failure. As mentioned in a previous note, risks that could end the game for you, are not worth taking.
A profit to owner salary ratio, or under paid owner, is a common thing for the IRS to look for. Doing this greatly increases your chance of getting audited.
Most owners whose books I've seen that do this, also take part in other "tax strategies" that hang in the gray area, or are outright illegal. So welcoming an audit is even more so not worth it for them.