Wealthpreneurs might think, “It’s my company – why can’t I pay myself whatever I please?” This mindset often comes from misunderstanding the relationship between salary and the return on equity ownership in the business. You get paid a salary for what you do, and you receive a return on what you own (profit distributions).
Don’t poke the beehive!
If you are not currently paying yourself a market-based wage, your net income number is lying to you. In fact, you are lying to yourself! Until you pay yourself a reasonable, wage that is not too high or too low, your financial data is worthless.
When you don’t pay yourself a market-based wage, your financials are distorted. And believe me, the IRS takes notice! Recently, the IRS audited 30,000 S corporation tax returns in two years because of this single issue. The tax law requires that owner compensation be “reasonable”, meaning it’s not too low or too high.
The Wealthpreneur Lesson
Milk, Don’t Barbecue!
Is your business a sick cow? If your company cannot afford to pay you a market-based wage and earn a profit that is at least equal to your industry average, then the answer is YES!
If you keep your cow healthy, you can milk it every day. Or, you can host ONE barbecue. The choice is yours!
The three bears of owner compensation
If you are accepting a below-market wage, you are overstating the profits of your business. As a shareholder or investor, you would never accept that outcome! Implementing a market-based compensation approach will reflect the true profitability of your business.
Additionally, Wealthpreneurs should not overpay themselves. Let’s imagine it’s the future, and you want to transition ownership of your business. If your compensation is overstated by $500,000 per year and the business is worthy of a 6X multiple, then a sale based on reported EBITDA (earnings before interest, taxes, depreciation, and amortization) would cost you $3 million of sales proceeds! Reported EBITDA is frequently “recast” at the time of exit, but consistently following a market-based approach to owner compensation will likely prevent an argument with prospective acquirers.
Paying market-based wages to all company employees (including the owner) creates a positive ripple effect within your business. Reasonable compensation can reduce turnover, increase workplace consistency, and raise your productivity, service quality, and customer satisfaction. It will also help you attract and retain top talent, fuel growth, and enhance profitability.
In addition, reporting a market-based wage on Form W-2 will help facilitate your access to future credit for home mortgage, HELOC (home equity line of credit), or other lending needs. This will prevent underwriters from “recasting” your financial results and calculating your compensation – which they might apply in a manner unfavorable to you!
Most tax professionals get this wrong!
In a recent study, more than 80% of tax professionals incorrectly responded to a question regarding how to properly determine reasonable compensation! Many Wealthpreneurs are victimized by advice from an unknowledgeable tax return preparerwhen a tax advisor would be more qualified to advise them on determining market-based compensation and its holistic implications.
Although the future cannot be perfectly predicted, it can be reasonably anticipated. Don’t let someone sell you a “tax plan” where you underpay yourself to save a few dollars in annual employment taxes. Wealthpreneurs will benefit most from holistic advice that considers the long term and multi-faceted aspects of reasonable owner compensation.
Will you still have Social Security tomorrow?
Questions abound regarding the future of Social Security payments. Will the Social Security Trust Fund go bankrupt in 2035? Will Congress take action to shore up the Fund’s finances? Will future benefit payments be limited based on a recipient’s other sources of income? No one knows the answers, but you can take action to better understand and possibly improve your future.
Reviewing your Social Security wage statement (available online) will tell you what wages you reported on Form W-2 over time and what your estimated Social Security payments will be upon retirement. If you decided to underpay yourself and simply distribute business profits, this can be a very sobering number! In that case, there will also be a negative impact on spousal, disability, and survivor benefits.
Take advantage of tax advantages
Regardless of how their business is treated for federal income tax purposes (S corporation, C corporation, or partnership), many Wealthpreneurs are interested in funding tax-advantaged retirement plans. These plans are subject to complex rules that can limit contributions under certain circumstances. In most instances, the key consideration is employee compensation (including owner compensation) as reported on Form W-2.
Employment tax-motivated reduction of owner compensation could limit your ability to take advantage of these retirement plans. A market-based owner compensation approach supports a proper funding level and minimizes risk related to an IRS audit or other regulatory review.
The insights above were inspired by the teachings of Greg Crabtree. For those interested in additional information, I recommend his book, Simple Numbers, Straight Talk, Big Profits!.
