Principles for Avoiding Owner Compensation Pitfalls

Seth Morgan

Seth Morgan, MLA Companies
June 2016

In closely held businesses, few tangible discussions are as emotional as compensation for owners, especially if those owners are family members.

Early in my experience as a business adviser, my client did what many do – equalize compensation for the owners.  To be “fair,” each owner was compensated equally as each of them was working full time in the business and each held an “officer” title.

When we challenged them to reconsider their “fairness” principle, the CEO insisted that it worked, and it did for five more years.  However, over time things changed and the “fairness” principle became a significant problem in their relationship.  After two years of arguing, bickering, and dialogue, three of the four owners decided to exit the business altogether.

Our client failed to address owner compensation, and as a result, discontent festered – eventually severing the ownership group.

As executives, we focus significant time on the compensation of our people.  We consider market rates, perform wage studies, meet with our staff and spend countless hours on compensation plans to help incentivize the behaviors we wish to encourage. Certainly, we can also spend a few minutes considering some wise principles for owner compensation.

What’s the Market?

Start by removing the name of “owner” from the position the owner fills.  What would you pay anyone else to be the CEO, President, top sales person, or any other role an owner plays?  Don’t place or keep an owner in a particular position, such as CEO, just because he or she is the owner. Ownership alone does not equal qualification for the job. We don’t pay employees if they fail to perform their duties, nor should an owner earn a salary because he or she holds a position they are ill-equipped to perform.

Likewise, consider the company paid perks for the owner in the same way.  What business expenses would you pay for any other employee in the same position?

Answering these questions is the starting point for considering proper owner compensation, but it is not the end.  There are plenty of ways to reward an owner for their investment and one very well may be a salary.  But honesty about the market rate of that owner’s duties is key.

Return of Equity

Providing a regular stream of cashflow to the owner as a return of equity (distributions, withdrawals, dividends) may be wholly appropriate; but it should be above and beyond any consideration of the market rate of the services provided by the owner to that company. Don’t conflate the two.

However, here’s a caution.  Depending on your business model and vision for the company, be careful not to distribute away too quickly the profits and cash earned by the business, even if it is the most tax advantaged treatment.  A healthy equity balance is important for certain industry financing relationships and a possible sale in the future.

Consider Taxation Separately

Too many companies try to answer the tax question before they answer the questions above.  Don’t get in the trap of organizing your business around tax planning (sorry CPAs).  Organize your business around principles and policies that will allow your business to grow, thrive, and become sustainable.  Once you answer the questions above, it is wholly appropriate then to meet with your CPA and discuss the various ways to accomplish the desired compensation.  And it might even be that you mix up the form of compensation (salary versus expense reimbursement versus return of equity) for tax purposes.  But you should always be able to answer with clarity the rationale behind the compensation for each and every owner.

Given the various tax and business ramifications, owner compensation can be tricky enough.  Once you introduce the emotion of family members or partners, it becomes even more difficult. A dose of good business principles and discipline will pay great dividends in the future.