Overpaid? Sometimes Paid? Owed Pay?

Most business owners try to find ways to maximize their salary toward the end of the year, and it never seems to be enough.

May 31, 2004

 

Alan Hanbury

Most business owners try to find ways to maximize their salary toward the end of the year, and it never seems to be enough. Those that find their remuneration to be satisfactory plan for it 13 months before D-Day, December 31. These owners understand the mechanics of profit and the value of keeping score all year long. They have contingency plans and firm pricing models.

In this segment we are going to investigate benchmarks for owner retirement benefits, salary packages with draws and distributions, and retained earnings. These are all intertwined, and you must use your business as a tool to reach your personal goals. Frankly, if your business cannot serve as this tool, then you should close it down and find a company or profession that can, and soon.

The urgent need to make and save money

Why the big hurry, you ask? Let's start with retirement. Anyone hoping to live well in retirement should be saddened to hear of the impending cuts to Social Security benefits, later retirement thresholds, and other ruts in the road to a happy and healthy retirement. I suggest that you read the writing on the wall and not plan on Social Security as a main source of income in your golden years.

Benchmarks, Part I
Net profit before deducting owner's compensation: 20%

Net profit before taxes: 10%

Retained earnings, S-corporations: 8-10%

Retained earnings, C-corporations: 12-15%

Owner's compensation: $52,000 or 10% of sales or return on equity + pay with differential + draws, whichever is highest. Does not include benefits.

Owner retirement benefits: 15% of owner's compensation, minimum

Software programs such as Quicken and Microsoft Money offer calculators that estimate required retirement savings based on income, returns, inflation, life expectancy and other factors. All work much the same. Unfortunately, numbers don't lie, and the usual required contribution is huge.

What might it take to make a comfortable retirement? I recommend annual income of 80 percent of the last three years' average salary. If you make $100,000, that's $80,000 in today's dollars. Assume the following factors:

  • 51 years old
  • retirement at age 66
  • live until age 86
  • $20,000 in current savings, with 8 percent return before retirement, 4 percent after retirement
  • $22,000 annual Social Security benefits upon retirement

According to the Microsoft Money calculator, this person would have to save an additional $30,000 each of the next 15 years. This particular scenario does not factor in inflation or any taxes! On the other hand, a 36-year-old with no existing savings account only has to contribute $7,800 annually to yield the same results.

This same sense of urgency should apply to those saving for college educations. With my two kids at private colleges, we will spend more than $70,000 a year for all college expenses, even with scholarships. If I had started saving at their births for that expense (and continued), it would have required $8,400 per year at 6 percent return until they graduated. Sadly, college costs are rising faster than the 6 percent earnings those accounts can safely generate. Factoring in 6 percent cost-of-education inflation, you would need to set aside about $21,000 per year if starting today with twins.

Can you see the correlation between personal and business goals? Have I made it crystal clear that as a business owner, your business has to be your partner in personal goals? Take a deep breath and read on.

What you want, what you need

First step, determine your current personal financial needs, wants and goals. Quantify what you need to make after tax to get to your personal income goal. Quantify possible benefits for which the company will pay. Perks - whether a company car, gas and tool reimbursement, full health coverage, $50,000 life insurance or tons of disability insurance - are almost all 100 percent tax free to you as an owner of an incorporated business. (In this day, there should be no sole proprietors. There is way too much risk in this business to have your personal as well as business assets on the line and available to creditors should something go awry. The cost to form a limited liability company is ridiculously low compared to those risks.)

Remember, an S-corporation needs to pay the owner a salary comparable to what an employee would be paid to do that job. This will keep the company off the IRS hit list for trying to evade FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and other taxes based on pay. After determining that amount, try to pack on tax-smart and "free" benefits.

Online retirement calculators
AARP: www.aarp.org Click on Money and Work, then Financial Planning.

CNN/Money: http://cgi.money.cnn.com/tools

Click on Retirement Planner.

Social Security Administration:

www.ssa.gov/planners/calculators.htm

Net profit and retained earnings for the business

With your personal goals and desired perks in mind, plan on a profit for the business. The general percentage target is 10 percent of sales before taxes. Profit fuels growth and upgrades your capital equipment and technology. Leave money in the company to make a banker feel better about you as a risk and as a cushion against bad times. Net profit also should be available for owners to remove as a draw or distribution. If you can't "afford yourself" in any particular year, you can use retained earnings (the company's previous and current net profits) to bring your pay up to your goals.

The minimum retained earnings for S-corporations is 8 to 10 percent of sales, and for C-corporations it is 12 to 15 percent. The amount you choose to leave in an S-corporation is very individual, but I suggest having either 12 months of your desired pay or six months of overhead without your pay. In either case, it lets you or your business survive a downturn without having to make foolish or desperate decisions you will regret later.

A C-corporation pays taxes on the money in retained earnings, and the shareholders will have to pay taxes again on those funds if distributed as a dividend or as next year's pay. Let retained earnings accumulate anyway, using at least the suggestions above for S-corporations. Stockholders should be rewarded with this investment in their company just as they would by buying the stock of a publicly traded company.

Owner compensation benchmarks

The company is taken care of, now what of the owner? Industry gurus say, and I agree, that 10 percent of sales should be the owner's compensation benchmark. I further propose:

  • The 10 percent figure should be gross pay and distributions, not counting labor burden and benefits, which doesn't pay for a meal.
  • Regardless of volume, set a minimum or floor of $52,000.
  • If there are two or more owners, their compensation should total 16 percent.

Why not 10 percent each? Each owner probably will perform some tasks that an employee also could handle, whether production, administration or estimating. The second owner's pay will come from the 6 to 8 percent of sales you would have paid an employee to perform those functions, and perhaps a small reduction in the primary owner's compensation for not having to do it all.

Alternatively, you can determine an appropriate salary by looking at a combination of return on equity, pay differential and distributions.

Return on equity: Return on equity is a risk reward for the value of your business. Calculate ROE, also known as ROI (return on investment), by dividing net profit by net worth of the business. To determine net worth, take retained earnings and add capital and treasury stock (usually $1,000 or less), say $80,000 total. If you had that in the stock market over a 10-year period, the return should have been 8 to 10 percent for a conservative investor, or 12 to 14 percent for the brave of heart.

However, a remodeling firm is far more risky than any publicly traded company. I propose assuming a benchmark ROE of at least 40 percent for C-corporations and 80 percent for S-corporations, which leave less equity in the company. So with a company net worth of $80,000, the first part of your pay would be either $32,000 or $64,000 for the privilege of risking everything you own, every day.

Don't look at ROE in a vacuum. For instance, 100% ROE on $1,000 in retained earnings is nothing to brag about. ROE's legitimacy hinges directly on having a properly capitalized firm.

Pay differential: You should make at least 25 percent more than the highest-paid employee of your firm. This premium is generated by factors such as risk, time involved in the day-to-day business, and personal goodwill generated with the public and past clients. If you have a salesperson earning $80,000, add $100,000 in salary to the ROE stated above. This $132,000 to $164,000 might be more than 10 percent of sales, but that would be the correct figure for this firm's owner.

Distributions: A third portion of pay, especially for S-corporations, is excess earnings that can be safely captured as draws, distributions or dividends, perhaps to help pay the owner's tax bill. Let's assume you remove half of the company's net profit and leave the other half in retained earnings. S-corporations still pay taxes on the entire net profit. If you achieve 10 percent net profit before taxes, another 5 percent of sales should be available as a distribution if the company has sufficient capital.

C-corporations should leave the after-tax portion of net profit in retained earnings. This allows owners to take palatable salaries in years when the plan didn't work, or to fuel growth and maintain health coverage and pension contributions in years that would normally require abstinence. You pull out the lightly taxed (15 percent on the first $25,000 profit) retained earnings when you really need them or as dividends to investors.

There are choices in setting pay; aim for the one that provides the best return. One thing should be a given: Pay is taken every week, come Hades or high water. Pay yourself first, and put the pressure on to sell, produce and collect. The answers are in front of you. You need to run the numbers and enlist your business as your partner in your future financial success.

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