Setting the size of your paycheck

Nation's Business, July, 1998 by Randy Myers

Deciding the level of your compensation requires a delicate dance--and your partner may be the IRS.

How much should you pay yourself? It sounds so simple. But if you own a company or plan to, this could be one of the most difficult questions you'll ever face because the answer changes over time as your company changes. And the decisions you make along the way might determine in part whether your business dies or thrives.

"The consequences [of a wrong decision] can be that at some point, there just won't be a company anymore," warns Howard Lewinter, a small-business consultant in Pittsburgh. "And you won't even know what happened."

Most discussions about what a small-business owner should take out of the company in pay focus on the pitfalls of taking too much. Big paychecks can rob a company of capital needed for growth, leaving it gasping for cash in tough times--the consequences suggested by Lewinter.

Unjustifiably high salaries also can alienate key stakeholders, including lenders, senior employees, and bonding companies. And sometimes overly high salaries can trigger tax penalties.

But when the owner's salary is too low, that too can have negative repercussions. Depending on the company's legal structure, the Internal Revenue Service may hit the owner or the firm with penalties if the agency decides that the salary was inappropriately low, or the IRS may hold the firm liable for an onerous "accumulated earnings tax."

Also, if the owner's exit strategy is to retire and have his or her heirs buy the company, the heirs could have difficulty financing the purchase if the owner's low salary over a long period of time has increased the value of the firm by leaving cash in it.

Unfortunately, there are no universal solutions to the problem of setting the owner's compensation, especially after the business achieves success. Even accountants and consultants sometimes disagree on how to approach the topic. Nonetheless, there are smart answers that can be tailored to individual circumstances.

"Money isn't merely dollars," Lewinter says. "It's a precious natural resource. Your challenge is to use that precious natural resource to build your company for the future."

Most owners have no trouble deciding how much to pay themselves when they're just getting their business off the ground. With start up costs eating into seed capital, there's often little cash left to fund a regular salary, much less a big one.

"We started our company with $3,500, which was all we had at the time," says Hyrum Smith, chairman and CEO of Franklin Covey Co., a leadership-development and productivity-training firm headquartered in Salt Lake City that now generates $600 million a year in revenues. "Staying financially viable was a daily concern, so we paid ourselves just barely enough to survive."

Raj Khera, president of Khera Communications, a four-year-old Rockville, Md., company that helps firms set up sites on the World Wide Web, says deciding to pay himself "zero salary" at start-up was "probably the simplest question I ever had to answer." Even today, he pays himself the minimum he needs to get by so that he can plow more cash into expanding the business, which has 10 employees.

The Growing Complexities

As companies begin to grow and prosper, salary decisions become more complex. When money is available, the owner must decide how best to spend it. The first issue to consider is almost always your company's legal structure and the tax consequences associated with it.

If your company is incorporated--and most companies of any size are--chances are that it's either a C corporation or an S corporation. In a C corporation, business profits that aren't paid to the owners are taxed by the federal government at a corporate rate that begins at 15 percent on the first $50,000 of income, jumps to 25 percent on the next $25,000, rises in two stages to 39 percent for the bracket of $100,000 to $335,000, and drops to lower rates for subsequent brackets.

"While there are many exceptions to the rule, most small [C corporation] companies are driven to reduce their corporate tax as much as possible," says Aaron Eidelman, a CPA and tax partner with Goldstein Golub Kessler & Co. in New York City.

The reason is to avoid double taxation. Profits paid out as salary or as a bonus to the company's owner are taxed only once, at that individual's personal tax rate. If money is left in the company at year's end and is paid to the owner later, the money gets taxed twice, first at the corporate rate in the year that it is earned and again at the owner's personal rate in the year it is paid.

Unfortunately, few business owners can predict precisely how much their companies will earn in a given year, making it hard to set salaries that will neatly eliminate all corporate profits. A common strategy employed by many owners of C corporations is to take a fixed salary that the company can afford comfortably throughout the year and then take anything left over at the end of the year as a bonus.