Figuring out how much to take in salary is never an easy equation for small business owners. How much is too much—or too little—and how that sum squares with the need to invest in the company are all issues to be considered. Neil R. Gordon, founder of N.R. Gordon & Co., has been providing small businesses with compensation and benefits expertise since 1995, and currently serves on the board of directors of two young technology companies. Recently, Gordon spoke with business writer Sharon Kahn about determining how much salary small business owners should take and why other forms of compensation can be just as valuable.
SK: Since the answer to the question ‘How much salary should small business owners take?’ undoubtedly depends on the profitability of the company, let's start with startups.
NG: When you don't have any sales, salaries don't matter. Even after you start raising investor money, you pay yourself as little as you need to survive, meaning to pay your rent and eat. Investors would say you're not going to need any money for entertainment because you're not going to have any time for entertainment. As you progress, salary might bump up a little higher, but cash is dear so salaries tend to be at the low end of the range. Of course equity rewards tend to be higher.
NG: No founder can be expected to work for free indefinitely. It might be important to establish some salary guidelines, depending on who your investors are, and possibly an agreement among the founders. Don't pretend that extended family is always friendly.
SK: What about more established small businesses?
NG: If you don't have outside investors, you get to decide what to pay yourself. Whether you own a professional practice or a barber shop, most small businesses owners say, ‘I wish I could pay myself more, but this is what I earn after I pay the expenses.’ Sometimes you have a good week and can pay yourself more, sometimes you don't.
If the company is larger and more successful but you still control it, you weigh the need for capital for expansion versus how much to take out. If the company is more mature and generating way more than it needs to invest, you get into tax planning issues.
If you have investors, the strategy revolves around how to spread the wealth. Now it becomes a matter of matching market salaries. To arrive at a more objective vision of what's fair, you can work with consulting firms or industry trade groups, which often track the average range of salaries in your industry by job description and size of company.
SK: What are some ways, other than salary, to pay yourself?
NG: Minimizing taxes is often an important strategy for business owners, and deductible expenses are an important aspect of that strategy. If you don't have outside investors, these can include club memberships, and a company car, for example.
Paying family members for legitimate work performed is another approach. I know a company in Rhode Island that made picture frames for commercial sales at places like Wal-Mart. The frames come with pictures of the owners' two-year-old granddaughter. For use of the picture, they paid her a modeling fee. The company gets a tax deduction, and the granddaughter, who is in a low tax bracket, can use that money for her college fund.
You can also delay some compensation. It's fairly common to base bonuses on three- to five-year results, when the amounts may be higher and the company can better afford to pay. If you're involved in tax minimization, you can also structure 401(k)s or other retirement plans so you're not getting fully taxed at your current level of compensation. And of course there's equity. Taking your company public or selling it will provide returns in the long term.
SK: Are there tax consequences to consider?
NG: I always recommend talking to a tax attorney and CPA to make sure you don't run afoul of the IRS and your other investors, too. Red flags can go up if you don't pay yourself enough. The IRS might view low wages as a ploy to avoid payroll taxes. And if you're not paying yourself enough because you're propping up the business, you may need to make some adjustments to become more profitable—or look hard at getting out.
Compensation is also an issue that comes up when it is time to sell the company. It's fairly common for sellers to point out that the books—and the tax records—show a profit or loss that includes all of your compensation planning. You might provide an analysis that shows what profits would be without payments for your plane, your country club dues, or your granddaughter's modeling fee. Then you can say, "If you make these adjustments, such as a fair salary for the CEO who's going to run it after me, you get a picture of a more profitable company." If you believe you may sell your business, it may be simpler to just pay yourself a fair salary and not have to provide explanations.
SK: How much should you pay employees? Don't the good ones expect a market wage and benefits?
NG: They do, but options or stock grants are common in startups. Stock is a legitimate form of salary—it is the primary reward above subsistence pay.
Of course, a family owned business won't want to give stock because [the owners] don't want to lose control, and the payday of going public or selling the business may never materialize for the employee. But you can set up profit sharing and perks such as a 401(k) match that can make up salary. You can, in effect, contract with your employees: I own all the shares, but if there's $100,000 profit at the end of the year, I get $90,000 and you get $10,000. This provides a similar incentive to employees as if they were shareholders.
This interview has been condensed and edited.
Since every small business is unique, before handling any salary issue, it’s wise to consult a tax attorney who can advise you on the best course of action for your company’s individual circumstances.