The Importance of Paying Yourself an Honest Salary
“How do I make the right decision for my business?” As a contract Controller I hear this time and again when working with Oregon brewers. When faced with a business decision it’s damn near impossible to know the right choice without having a clear view into how it will affect your finances.
There are a handful of ground rules that I follow to help breweries establish a solid financial footing. One of the most important is that owners should pay themselves a market-based wage. Allocating a reasonable salary for yourself in the Profit and Loss Statement will give clarity to the true performance of your business, which allows you to make informed decisions. If you have paid yourself an unreasonably low salary in order to show net income those numbers are distorted. You may feel good about your profit, but the bottom line is a facade. Viewing true numbers will help you make informed decisions and allows you to compare your brewery apples-to-apples against industry metrics.
So what is a reasonable salary? There’s no definitive answer – think of it as what would you have to pay someone else to do the same job. There are a number of salary research websites can provide guidance. Strive to pay yourself a market-based wage and live off that salary. Then be disciplined enough to leave after-tax profits in the business until it is healthy and you reach your core capital target. After that you can start to take distributions.
If you have trouble paying yourself a market-based wage and making a profit it would be wise to examine your business model. Of course there will be ups and downs, and in the start-up phase we can expect a ramp-up time of net loss as operations get ironed out. But if the issue persists you can be sure that some details of the will need to be tweaked. If you can’t make it pencil, the business model is unsustainable.
Additionally, this ground rule ensures adequate tax compliance if you are an S-corporation. Let’s say your W-2 wages are $30,000 for a job that’s really worth $90,000. Then you as a shareholder take out another $60,000 as distributions. If audited the IRS would likely determine that the additional $60,000 should be salary subject to payroll taxes. If you had run the entire $90,000 through payroll the IRS would have gotten their portion of Social Security and Medicare taxes, but when you pay yourself a portion as an owner’s distribution (i.e., not paying the Social Security and Medicare) the IRS may claim that they have been shortchanged on tax owed.
But what if you have outside investors? How can you justify paying yourself a large salary when other people have lent you money? I suggest agreeing with your investors what your long-term market-based wage will be. Then take a lower wage until the financial backers have been repaid their initial investment. At that point you can increase your salary to the agreed-upon rate and after-salary profits can be shared among all investors. Be up front with financial projections and create forecasts of a best-case, worst-case and midline scenario – this is a critical part of managing investor expectations.
Finally, paying yourself a market-based wage allows you to plan for your exit from the entity. If you are not paying yourself a adequately then you have to be prepared to pay more to bring in someone to do your job. This will raise expenses and negatively impact net income. Trust me, you don’t want to start a conversation with a potential buyer without solid financials. Do yourself a favor and get your numbers accurate right from the get-go. You never know when InBev will come calling…