One common question we receive from our clients, especially service businesses, is how to compensate the owners of the business and what considerations should be taken into account when determining such compensation.

Entity structure and owner compensation

There are a few different ways to compensate owners, depending on the type of entity. The form of entity and payment affects how you are taxed and can vary significantly.

One of the most common ways that owners receive compensation is with W-2 wages (wages), Compensation paid by wages is an expense for the company and is reported as income on the owners’ 1040. Wages require that the company pays the employer share of Social Security, Medicare, and unemployment taxes. Both C corporations and S corporations can pay owners wages; however partnerships, LLCs, and sole proprietors cannot.

Partnerships, LLCs, and sole proprietors instead pay owners by distributions. All owners pay income tax on their share of the company’s earnings, so when distributions are made to the owners, they do not pay additional income tax on those distributions, and they are not deductions for the company. Health insurance, retirement contributions, and other fringe benefits can also be provided to the owners but are considered distributions to the owners. These are deductible by the owners on their individual returns rather than by the company. In a service business, where the owners are doing the work, the income that is allocated to the owners is also subject to self-employment tax with the employer and employee portion paid by the owner.

S corporations are unique in that they can also payout distributions, in addition to any wages, but they must be paid out pro rata to its owners based on their shares in the corporation. If a different allocation is required, it must be paid as wages to the owner(s).

Partnerships and LLCs can also use guaranteed payments to compensate owners. A guaranteed payment is typically outlined in the operating agreement and is used to compensate an owner for providing additional services, such as managing the company. It is deductible by the company and considered income to the owner receiving the guaranteed payment.

Considerations in calculating compensation

In determining the amount of compensation, whether by wages, profit allocations and distributions, or guaranteed payments, there are several factors to consider. The biggest question is what feels “fair” which can look different, depending on the situation, and can mean something different to each of the decision makers making this an even more difficult discussion. Therefore, it is important to make sure that the owner compensation formula is well documented and that it aligns with the company’s culture and goals, while still motivating owners.

Many professional service companies such as doctors, engineers and lawyers may choose to determine compensation based on productivity which can be measured by number of patients/clients served, collections, client originations or other factors unique to their business. Often, base compensation is paid with bonus calculations done at the end of the year to account for various metrics. Others may choose to compensate everyone equally if everyone does a similar amount of work.

Some considerations to determining a fair compensation formula are:

• Does the compensation set up our company for future success and align with cash flow needs?
• How do we split revenues – equally or by collections, charges, hours, clients served, or other metrics?
• How do we split expenses? Should everyone cover an equal amount of expenses, or should some expenses be covered by those using more of the personnel, equipment, space, etc.?
• What other benefits are received, such as health insurance and retirement contributions, and how do we want to account for them?
• How are administrative duties split? Do one or two owners perform the administrative duties and should they receive additional compensation for that?
• Are there any buy-in considerations when bringing on a new owner?
• Is the compensation competitive with industry standards?

As you can imagine, there is not a one-size-fits-all answer to this question.  At Snyder Cohn, we work with a number of businesses to address these types of issues. If you would like to discuss this further, please do not hesitate to reach out to us.

By:  Melinda Kloster, CPA and Kaitlin Deimler, CPA