Owners who pay themselves generously should also beware. In a recent Tax Court case, Multi-Pak Corp. v. Commissioner, the IRS challenged a C corporation owner for paying himself excessive compensation to reduce his company's tax liability.
You should, therefore, try to strike a balance between under- and overpaying yourself.
Special rules for start-ups
If you're just starting out, setting your salary is relatively easy. Pay yourself enough to cover your bills and living expenses — and no more. You can increase your salary as your business grows by pegging it to profit growth.
Even if you have another source of income, resist the urge to pay yourself nothing. Lenders and investors expect to see salary projections in your financial statements. It helps them estimate when you'll be profitable and able to repay debt, and it shows them you're realistic about what it costs to run a business over the long term.
Mature businesses
If your company is safely in the black, determining your salary can be more complicated. This is particularly true if you run an S or C corporation, where the owner's compensation affects tax liability.
Some owners set their salary based on informal metrics, such as what they were paid as an employee elsewhere, what they think they're worth or even what their friends and business peers would expect them to earn. A more reliable method is to incorporate factors that the Multi-pak court considered when determining reasonable compensation. Consider, for example:
Your role. Take into account your responsibilities, hours worked and the value you bring to the business, such as your reputation and customer relationships.
What others pay. Find out what owners in your industry, in your geographic region and of similar-size companies pay themselves.
Character and condition. Consider your company's size as measured by sales, net income or capital value; the complexities involved in running it; and general economic conditions.
Internal consistency. Compensation should be fairly consistent year to year. Dramatic increases or cuts can be an IRS red flag. Your salary also should bear some relationship to those of your employees.
Potential conflicts of interest. The IRS looks out for C corporation owners who disguise nondeductible corporate distributions as compensation. S corporations raise red flags for doing the opposite — reducing salaries and bonuses and instead paying owners via distributions. By taking a lower salary, the owners are able to reduce, often significantly, their payroll tax liability.
Stay in control
Don't let salary issues jeopardize your business's — or your own — future. Given the complexities, owners of C or S corporations need to get professional tax advice when determining the amount, form and timing of their compensation. •
Other articles in the January 2012 Edition of Business Matters: