One of the toughest questions business owners wrestle with is, “What do I pay myself?” It’s a fair question. Get this wrong, and you can end up with a lot of unnecessary tax. You can also get a false sense of confidence in how your company is performing because you are underpaying yourself.
Simple example: Tim’s company ‘makes’ 25% EBITDA (that’s Earnings Before Interest, Tax, and Amortization – the financial metric most often used to assess your operating performance because we’re looking at earnings before the costs associated with interest, taxes, and the amortization of intangible assets are deducted). Now, for tax purposes, Tim’s followed BGW’s advice to the letter and has his wages dialed in to maximize tax efficiency. At the country club and in his peer group, he’s bragging about his EBITDA and, in fact, he’s at the top of the class for his peers in industry. Thus, when thinking about changes he needs to make in his organization, his thought is, “Ain’t broke, don’t fix it.” Question is, is he right?
The facts are that Tim pays himself $50,000 a year and is working 80 hours a week, takes $75,000 in distributions, when in fact he could be making $250,000 a year working for someone else. In this scenario, Tim is really operating at an economic loss when viewed from how he should be performing.
Another simple example: Sally’s ego demands that she be the highest paid person in the company. Her salesperson had an amazing year and will make $500,000. Sally boosts her salary to $600,000, so that her ego can say she’s still the highest paid person in the company, and the company breaks even from a tax perspective. Did she do the right thing?
No again. Sally left a lot of tax money on the table in the form of a lower tax rate on the distributions. She should have accepted the lower salary level.
So, how do we advise our business owner clients on this topic? We look at reasonable compensation with three questions in mind:
- For your own internal tracking and reporting, what’s a fair salary? (Regardless of tax treatment, this should be tracked as an expense line item, otherwise you are subsidizing the company and not pushing yourself hard enough.) ‘Fair’ for most businesses for a CEO starts at a floor value once you have a few employees. In our opinion, that floor is $150,000 and should max out at around 10X the average salary level of all your employees, the current ratio of CEO to worker pay in Japan and the ratio that used to be the US standard before CEO pay become short-term stock incentive performance based.
- If I were a passive investor, what would I demand as a dividend payment on my investment? Great question! If we look at the data, the average dividend yield of the S&P 500 is 2%. Dividend yield is the percentage of a dividend paid relative to total company value, so if a company is worth $100, it is paying annually a dividend of $2. To truly dial in what your company is worth, you should get some benchmarking information or have a simple valuation done, but for ease of this calculation, we have found that using the greater of 1X gross profit or total equity is a good enough estimate for this purpose.
So, if I have a company that has $200 in sales, $100 in COGS (so gross profit of $100), as a passive investor, I should demand a minimum of $2 cash each year. If said company has $75 in overhead (so EBITDA of $25), its percentage is 12.5%, and it should be paying out a dividend of 10%. But this is also an illiquid investment, so if you apply commonly used risk factors that are utilized when valuing a company for lack of liquidity, your expected dividend yield would be 2% X 1.33, or 2.67%. Make it easy and round to 3%.
The point here is that if your company isn’t at least funding you 3% of its value every year, after paying debt, keeping a working capital reserve, and funding money to pay your income taxes (those don’t count for this purpose!), you have a performance problem you need to solve.
- What do you do for the tax man? This is really easy.
a. If you are operating at a loss, don’t do anything – chances are your salary is creating the loss. You are thus paying unnecessary social security taxes.
b. If you are making below $400,000 (round numbers for this purpose, the actual formula would be the current social security wage limit X 2), use a ratio of salary to distribution of at least 30% / 70% and no more than 50% / 50%.
c. If you are above $400,000, use a range of social security limits to max wage requirement to fully contribute to a retirement account, which as of 2024 is $345,000.
If you keep in these windows, our experience shows you should be safe from IRS scrutiny, as you have ample case law on your side pending any legislation from Congress to the contrary.
So, what now? Here are the takeaways:
- If your company cannot pay you your (literally your) market rate AND also pay a dividend to you, you have a performance problem you need to focus on. Fix it. Then reevaluate your package each year for internal tracking purposes to stay on your game.
- Completely different from (1), set a compensation that doesn’t create unnecessary taxes and report differently on your tax return, W-2.
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