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Barbara Weltman

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5 Factors to Consider in Setting Compensation for Owners

November 5, 2024 / By Barbara Weltman

5 Factors to Consider in Setting Owner's CompensationAs 2025 approaches, businesses are working on their budgets, and one important aspect is how much should owners be paid? The decision has important consequences for deductibility, payroll taxes, cash flow, benefits, and more. This is a topic I’ve explored in prior blogs (some points of which are repeated here), but it bears further examination.

1. Type of entity

One of the confusing things for some business owners is clearly understanding the impact that entity choice has on compensation. In a nutshell (and somewhat oversimplified):

  • If the business is incorporated, then an owner performing services for the business is an employee who can take a salary and other benefits. The corporation deducts compensation, which is subject to employment taxes. The owner reports the compensation as income on his or her personal return.
  • If the business is unincorporated (sole proprietorship, partnership, limited liability company), there is no such thing as a salary. The owner can take a draw (a regular payment akin to a paycheck), but it’s not deductible by the business. There are no employment taxes on the draw; the owner pays self-employment tax on his or her share of profits, regardless of the amount of the draw. Note: An LLC can elect to be treated as a corporation for tax purposes and then make an S election so that the owner can receive a salary.

2. Deductibility

Whether a corporation can deduct an owner’s compensation depends on whether it’s reasonable under the circumstances. The tax law has 2 tests with respect to compensation for owners of privately-held corporations that are used by courts when the IRS denies a deduction on the grounds that the compensation is unreasonable; courts use one or the other:

  • 5-factors test. This looks at (1) the owner’s role in the company (services being performed, personal skill, etc.), (2) an external comparison (a comparison to compensation by other companies to similar people performing similar services), (3) the character and condition of the company (size, complexity, general economic conditions), (4) conflicts of interest (the ability of an owner to designate a payment as compensation rather than treating it as a nondeductible dividend), and (5) internal consistency of compensation (whether payments are made pursuant to a structure, such as authorization by the board of directors).
  • Hypothetical independent investor test. This looks at how much could be paid to an owner while still providing a hypothetical investor with a reasonable return on investment.

3. Payroll taxes

Payroll taxes apply to compensation; they don’t apply to other types of distributions to owners. These other distributions may be:

  • Tax-free fringe benefits. Owners may be able to enjoy many of the same tax-free perks they offer to their staff. There are limitations on some benefits due to nondiscrimination rules and other factors, but these benefits are usually free of employment taxes and not subject to withholding. The IRS has a list of fringe benefits you can explore.
  • Dividends. These are nondeductible payments made by a corporation out of its earnings and profits. If a payment is called compensation but should be treated by the corporation as a dividend, it’s referred to as a disguised dividend. Sometimes a disguised dividend arises where the corporation pays personal expenses for an owner. (The issue of dividends usually relates to C corporations, and not S corporations.)
  • Loans. These are arrangements that give owners the use of money that should be repaid. It is highly advisable to formalize loans by using a promissory note setting forth the terms of repayment, the interest rate, and other conditions. If the loan has an interest rate below an IRS-set applicable federal rate (AFR) for the term of the loan, this creates “phantom interest” that is income to the corporation.

The dilemma of fixed compensation versus other types of payments—perhaps to minimize employment taxes—is especially important to S corporations. What’s reasonable compensation for S corporation owners who provide substantial services to the business so that the IRS won’t challenge the amount? There’s an old IRS Fact Sheet discussing wage compensation for S corporation officers, and the factors for determining reasonable compensation that are laid out in it still apply today. So, it’s sort of a Goldilocks situation. You want only enough compensation to avoid an IRS challenge, but you don’t want to over-allocate payments as compensation when they could be treated as distributions exempt from FICA.

Some tax professionals suggest that setting compensation for S corporation owner-employees at the Social Security wage base–$176,100 in 2025—is “reasonable.” I’m not so sure this is a good strategy. What’s reasonable in one situation may not apply to another, and the wage base is not necessarily a measurement of reasonableness. Look at the situation at hand to fix reasonable compensation.

4. Practical considerations

Whether it’s a salary or a draw, disbursements to owners depend on some practical issues:

  • Profitability. Business owners may scale their personal payments to how well the business is doing. In good times, there are good payments. In tough times, they may reduce or forego payments to help the business succeed.
  • Cash flow. There needs to be cash on hand (or a line of credit to draw on) to make a payment.
  • Employment taxes (an additional cost for salaries paid to owner-employees).
  • Hours worked. SCORE reported that 39% of small business owners work more than 60 hours a week. Payments to owners may be tied to how much time they put into the business (i.e., whether they work daily or are essentially investors).
  • Impact on retirement savings (contributions to a corporation’s qualified retirement plan is dependent on the owner-employees’ compensation).
  • Impact on the QBI deduction for owners of pass-through entities (i.e., businesses other than C corporations), where W-2 wages for owner-employees are an important factor in figuring the qualified business income (QBI).

5. Payments in today’s market

Most owners set compensation for the coming year based on what they’ve already been receiving; they merely adjust it for inflation and factor in the company’s prospects for the future. Some owners take an amount each pay period needed to cover their personal expenses and then take a bonus at the end of the year based on the company’s performance. Of course, this depends in part on how much money will be plowed back into the business.

Business News Daily has some tips for setting compensation. According to Payscale, the average annual small business owner salary in 2024 is $69,647.

Final thought

“You don’t get paid by the hour. You get paid for the value you bring to the hour”-– Jim Rohn, American entrepreneur and motivational speaker

The clock is ticking, and it will be 2025 before you know it. As the owner of a business, what will you pay yourself? An initial pay schedule can always be adjusted during the year as profits rise—or fall. Discuss your thoughts and concerns with your CPA or other tax or business adviser.

For more information on entity choice, see blogs here.

Tags business owner's compensation compensation and benefits entity choice payroll taxes small business owner

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