As a business owner, determining your own salary can often seem like navigating a complex maze blindfolded. It’s not just about what you believe you deserve, but what you would pay someone else to do the same job. This article dives into the distortion in true financial performance of your business when you do not pay or account for a market based wage.
Understanding the nuances of owner compensation is not merely a matter of legality; it profoundly impacts your company’s financial health and how you perceive its profitability. By the end of this guide, you’ll have a clearer understanding of how to set a salary that not only reflects your role and contribution but also positions your business for sustainable growth and minimizes risks like IRS audits.
We’ll explore practical steps and real-world examples, drawing on the expertise of financial management guru Greg Crabtree, to ensure your owner compensation strategy promotes a robust, transparent financial future for your business. Let’s delve into the principles that will help you make informed decisions about your salary, enhance your business’s profitability, and prepare you for its future phases.
Understanding Owner Compensation
"You get paid a salary for what you do, and you get a return on what you own."
When business owners set their salaries, don’t confuse what you are “able” to pay with what you “should” be paid.. It is not uncommon for the owner to skip a paycheck when funds are tight, but you still should accrue the skipped paycheck so you see the financial impact and you can track what you should get at a later date when it is available. A market-based wage refers to the salary that someone in the owner’s position would typically earn in the market for managing similar business functions and responsibilities. Contrasting this, a return on investment (ROI) represents profits (and hopefully dividends!) based on the owner’s investment in the business, not their role or the work performed. Misunderstanding these concepts can lead to various issues, including distorted financial statements and tax imbalances.
"Most entrepreneurs think they are overpaying themselves, but at least 90 percent are underpaying themselves."
Many entrepreneurs fall into the trap of underpaying themselves to minimize expenses and maximize profits. While this might appear to enhance financial short-term health on paper, it often leads to a skewed view of actual business profitability and stunted personal income growth. For US based S corporations, underpaying owner wages can lead to an IRS audit for back payroll taxes. Conversely, excessively high compensation can lead to cash flow problems.
Therefore, defining and adhering to a market-based wage is not merely a formality—it’s an essential strategy for transparent financial reporting and long-term business sustainability. It helps align the owner’s salary with industry standards, ensuring both compliance and a realistic picture of business performance.
The Concept of Market-Based Wage
A market-based wage for an owner is determined by the salary an individual with similar skills and responsibilities would earn working for a different company in a similar industry and location. This method ensures that compensation reflects the true value of the owner’s contribution to business operations. It is vital to differentiate this from a return on investment (ROI), which relates to profits attributable to the business owner’s equity in the business.
How to Determine Your Market-Based Wage
Determining your salary can be confusing but there are tools for you to take aim and calculate your target salary more accurately. To accurately determine a market-based wage:
- Identify Comparable Roles: Search for job positions that match your day-to-day responsibilities and the level of expertise required. Greg Crabtree says “Think of it like this: If you got run over by a bus today and your heirs decided they would keep the business going in your absence, what would they have to pay someone to do your job?“
- Multiple Roles: If you do more than one role in the business, evaluate the percentage of your time spent in any role that is over 10% of your time in the business. Do a market wage survey for each role and apply the percentage of time spent to each role to come up with your blended wage. Then focus on the lowest compensated roles to be the first roles you delegate.
- Use Salary Benchmarking Tools: Websites like Salary.com can provide up-to-date information on wages across various industries and regions. Input your job title, industry, and location to receive a detailed compensation report. Another trusted salary survey site is the Economic Research Institute’s Salary Survey Assessor but it does require a subscription. Some numbers on online compensation data tools may be overinflated but even after adjustment are likely to be much higher than what you are paying yourself currently.
- Consider Consulting Industry Reports: These reports can offer insights into compensation trends and standards in your specific sector. Beyond publicly available sources, Greg Crabtree offers his Simple Numbers Private Company Economic Update Keynote provides industry-specific trends and insights that offer valuable information for determining market-based wages.
- Adjust for Company Size and Location: Salaries can vary significantly based on company size and geographic location. Adjust the market-based wage accordingly to reflect these factors
Implications of Incorrect Salary Settings
Without a market-based salary, your net income number is lying to you, or you’re lying to yourself. Realistic wages ensure your business is heading in the right direction. It truly is a key foundational building block that clarifies many other questions further down the road.
Potential IRS Audits Risks and Legal Compliance Issues
"If you're not paying taxes, there are only two possibilities: You didn't make any income or you're cheating."
Setting an owner’s salary too low or too high can trigger IRS scrutiny, potentially leading to an audit, and nobody wants an audit from the IRS. The IRS monitors compensation to ensure it aligns with industry standards, checking if owners are evading payroll taxes by disguising salary as corporate profits. During the past couple of years, the IRS has audited thirty thousand returns of S corporations based on this issue alone.
Beware of the effective tax rate trap. People will promise to lower your tax bill to 10 percent or less by luring you into spending your profits to lower it. While you may pay less in taxes you won’t ever build any wealth. Evading taxes shouldn’t be your focus, increasing profits should be.
Proper salary settings not only prevent legal pitfalls but also safeguard the owner against potential fines and penalties associated with non-compliance.
Impact on Business Financial Transparency and Decision Making
"It's my company- why can't I pay myself whatever I please?"
Incorrect salary settings can mislead stakeholders about the true financial performance of the business. For instance, an inflated owner’s salary might suggest higher operational costs, while a deflated salary can artificially inflate profitability.
For instance, owners Chase and Davis were neglecting their own wages because their net income was more than 20% of sales; or at least they thought. After adding their salaries and distributions together and treating this number as the true market-based wage, Chase and Davis were only making 5% before taxes.
Both sales figures and net income are irrelevant if business owners don’t account for a true market-based wage on their finances.
Additionally. your Social Security payments can be affected when you retire if you report low wages over years and your W2 earnings totals reflect your low wages.
By aligning the owner’s compensation with market standards, businesses can achieve a clearer financial picture, which is crucial for effective decision-making and securing investor confidence. Accurate compensation also facilitates better budgeting and financial planning, essential for guiding strategic business growth.
Tackling Salary Structure Challenges
As we’ve seen, determining a market-based wage is a critical step in ensuring the transparent financial health of your business. However, it’s not uncommon for business owners to struggle with this process, particularly when faced with budget constraints or concerns about investor perceptions. Here are some practical strategies to address these common challenges.
Tracking and Accounting for Sweat Equity When Salary Payments Aren't Feasible
"You shouldn't pay yourself a market-based salary when your business can't afford it."
In many startups and small businesses, cash flow might be too tight to support regular market-based salary payments. In such cases, it’s essential to quantify the ‘sweat equity’—the time and effort you invest without immediate financial reward. For example, if your salary should be $120,000 and it takes two years before you can take a salary you have created $240,000 in capital through sweat equity. Documenting this contribution can be crucial for future compensations or equity distributions. Many financial reporting tools fail to give you the ability to track special items such as sweat equity, so you may find yourself manually taking the data and putting it into a readable format.
It’s advisable to periodically evaluate the worth of your sweat equity, adjusting your compensation when the business becomes more financially stable.
Setting Clear Compensation Policies for Multi-Shareholder Scenarios
"Quantify everything, and put it in writing."
When multiple shareholders are involved, establishing transparent compensation policies is crucial. All parties must agree on how salaries are determined and adjusted. This agreement should be documented and revisited regularly, taking into account the growth of the business and the roles of each shareholder. Regular meetings to discuss compensation can help avoid misunderstandings and ensure everyone feels equitably remunerated for their contributions.
For example if you are the “effort partner” meaning you are doing the active work, and have a funder, also known as a money partner, profits and losses of the business should be allocated to the money partner until that partner recoups the initial investment. You may take less than market-base salary initially and pay back your money partners sooner. The key is don’t get stuck taking less than what you’re worth. It’s important to move to a market-based wage at some point. All investors should have realistic expectations about salaries now and in the future.
By implementing these practical steps, business owners can ensure their compensation strategy is fair, competitive, and compliant, aligning with their business goals and financial capabilities.
Strategic Benefits of Proper Salary Compensation
Proper compensation strategies extend beyond merely fulfilling legal obligations; they play a crucial role in driving organizational success and sustainability.
Enhancing Business Profitability and Sustainability
Proper compensation for business owners directly influences overall profitability and the long-term sustainability of an enterprise. By implementing a market-based wage, owners ensure that the business’s earnings beyond this salary reflect genuine profitability, which is integral for accurate financial assessment and planning. This clear distinction between salary and business earnings aids in better financial forecasting and resource allocation.
Employee Retention and the Influence on Organizational Culture
"Market-based wages apply to everybody, not just the shareholder."
Setting a precedent with a market-based wage for owners also sets a standard for employee compensation. It demonstrates a commitment to fairness and transparency within the company. This approach not only facilitates in attracting competent talents but also significantly boosts employee retention. Under-compensated employees often leave and cost you more money in the long run as you have to find a replacement. If they don’t leave then they tend to be less productive and produce lower quality work which can also be expensive. A transparent compensation model enhances the organizational culture, nurturing a more dedicated and motivated workforce which, in turn, contributes to the business’s stability and growth.
Preparing for Business Growth and Scalability
Correct owner compensation is pivotal when preparing a business for scalability. With a proper salary structure, business owners can more effectively gauge the impact of scaling operations on expenses and profitability. Moreover, it sets a structured blueprint of financial management that can be replicated in new locations or departments, ensuring the consistency and efficiency needed for successful expansion. This strategic approach allows for controlled business growth without compromising operational or financial integrity, empowering owners to make informed decisions about future investments and developments.
Transitioning the Salary Structure
As your business evolves, so should the salary structures within it, including the owner’s compensation. It’s crucial to frequently reassess and adjust salaries to ensure they align with current market conditions and business performance. Set regular intervals, for example, annually, to review salaries against market benchmarks. This ensures compensation remains competitive and appropriate, fostering a motivated workforce while maintaining financial balance.
Managing Salary Expectations with Investors and Partners
Transparent communication with investors and business partners about salary changes is vital. Explaining the basis of salary adjustments helps maintain trust and supports the collective understanding of financial decisions impacting the business. Engage with your stakeholders during salary review periods to discuss the rationale behind changes, be it growth targets, additional responsibilities, or inflation adjustments. This collaborative approach notifies them of your commitment to fiscal responsibility and shared success.
Planning for Transition from Active Management to Shareholder Role
"Consider working on a limited capacity at a lower wage as you transition out of active management."
As business owners plan for a future where they might take a step back from day-to-day operations, rethinking compensation becomes key. Earning a market-based wage while you are the single shareholder makes it easier to transition out of the business and hire another general manager without negatively impacting your business’s net income.
During this transitioning phase to a shareholder or advisory position, consulting with financial advisors to set up profit-sharing plans, dividends, or other forms of owner returns that reflect this new role can ensure a smooth and financially sound transition. This strategic shift not only secures the owner’s financial future but also supports the business’s sustainability and leadership succession planning.
Don't Let Your Numbers Lie
Understanding and setting the correct owner’s salary isn’t just a matter of compliance, it’s a fundamental aspect of your business’s financial health and growth. As we’ve explored, aligning your compensation with the market rate and your contribution not only enhances transparency but also safeguards against legal pitfalls and financial misrepresentation. Whether you’re just starting out or are looking to recalibrate your salary structure, it’s crucial to base your decisions on sound financial principles and reliable data.
If you’re ready to delve deeper into optimizing your compensation strategy or need tailored advice to navigate the complexities of financial management, consider reaching out to Greg Crabtree. Through his books, speaking engagements, and workshops, Crabtree can help you transform your business into a profitable entity while ensuring compliance and promoting sustainable growth.
