The Entrepreneur’s Salary and How It’s Affecting Your Numbers

by Michael Hsu on July 31, 2012

A lot of business owners end up shortchanging themselves and their business by failing to set themselves a market-rate salary. They either overpay themselves by taking too much revenue out of their operation or underpay themselves by not setting aside enough income, thereby distorting their numbers. Either way, this end up harming the business.

The Difference Between What You Do (Salary) and What Your Earn (Profit)

As the owner and the CEO (or sales or COO or insert-creative-titles-here) of your company, you should be getting paid twice - once for the “work” you do and once for the “profit” the business earns. Unfortunately, many entrepreneurs focus solely on the later and neglect the former. This is the core problem that skews the financial data of most small to medium sized companies.

Check this over-simplified income statement out – the one on the left did not account for the owner’s market-rate salary for what he does and the one on the right did.

By simply accounting for the owner’s salary – the company went from a we-are-doing-okay 7.65% in net profit to a dangerous 1.76%.

So? What is the Big Deal?

Many entrepreneurs believe this is not a big deal because they are still getting the money at the end of the day assuming they own 100% of the company. In fact, their cut-rate tax preparers might even be the one advising them to do so to “save a few bucks on payroll taxes.” Well, besides the obvious reason of it being illegal, you are just lying to yourself about the health of your business.

Look again at the example above. The two companies are in vastly different stages based on the story the numbers are telling me.

At the fake 7.65% net profit – I would be lying to myself (and everyone else who rely on these numbers to make decisions) thinking that my company is doing an okay job at surviving. I may even feel like I could afford a little more admin cost to hire that office assistant everyone was asking for. I could be working on scaling my business under this financial model – after all, 7.65% of 10 million sounds pretty good. It certainly beats leaving this money in the bank.

On the other hand. If I am looking at the real number of 1.76% net profit – alarms will be going off everywhere in my company. Something is really wrong here. I would be reviewing my numbers with my entire team to figure out what is broken and the necessary actions steps to turn things around. If I can’t fix it, then I should probably get a job and know that there are tons of opportunity out there that I can make more than 1.76% return on my money.

Clarity and having a clear sense of direction is of vital importance to a business of any size. But for a startup or small business it is absolutely essential that your numbers accurately reflect the state of your business. Without factoring in an owners salary at the market-rate, you are needlessly muddying the waters.

  • http://twitter.com/AccountechsAZ AccountechsAZ

    There are times when it is entirely appropriate, and perfectly legal, for a small business owner to take less than the prevailing market wage. To say that it’s always wrong is a gross oversimplification, at best.

    Let’s say the client is a disregarded LLC, as just about every small business I know is, and the owner is in the 25% bracket personally. Also assume market puts him at $110K/yr salary, but he pays himself $55K. (Not illegal at all. That only comes into play with a corp, and then it only has to be a “reasonable” wage.) Finally, assume Net Income of $40K on the company after the owner’s $55K wage.

    Ignoring deductions and just looking at taxable income, in this scenario the client pays $13,750 in personal tax, plus $4207 in ER tax, on that $55K wage. Plus $9618 in income tax and $3060 in SE tax on the passthrough income. Total tax bill is $30,635.

    Now look at $110K salary. Client pays $27,500K in personal tax plus $8,415 in ER tax on the $110K. Nothing on the passthrough income because the company now has a $15K loss. Total tax bill is $35,915

    Under no circumstance will I cause a client to pay $5,280 more in tax just so they can have the most theoretically accurate P&L on the block. I’d gladly leave the P&L “wrong”, and consume some of that tax savings in billable time to teach the client financial fluency.

    This might work fine in a what-if scenario, where you show a client what the business “really” looks like versus the statements as prepared. I just take exception with calling sound tax advice bad business.

  • http://www.deepsky.co W. Michael Hsu

    Hello AccountechsAZ -

    Thanks for your reply. 

    I’d point out that you are thinking from the aspect of a tax accountant and not from the perspective of an entrepreneur or his business.  

    By focusing too much on the tax impact of the business, you are working on the wrong end of the horse. The $6,000 in tax savings could be nice, but how many $6,000 is he going to have with a company that is losing $15,000 an year according to your example?

    Additionally, if the said business owner is making $55k while doing a $110k job. Why wouldn’t he simply go out – do what he does – and get paid the $110k without any of the trouble or headaches or risks that come with owning a business? Even if you add the $40k “profit” – that’s $95k for a $110k job. Why?

    Secondly, by under paying himself for what he does, it grossly misstates the health of the business. Under your calculation, the company is making a healthy $40k profit when in reality, it is losing $15k each year. I’d argue that a business that loses money over time is not a business at all but rather an expensive hobby. 

    I like your last statement about showing the customer what the business “really” looks like. But isn’t that what financial statements are for? Isn’t accounting created to first help entrepreneurs see the truth of their business in order to make better financial decisions? I’d like to think so.

  • http://www.deepsky.co W. Michael Hsu

    Hello AccountechsAZ -

    Thanks for your reply. 

    I’d point out that you are thinking from the aspect of a tax accountant and not from the perspective of an entrepreneur or his business.  

    By focusing too much on the tax impact of the business, you are working on the wrong end of the horse. The $6,000 in tax savings could be nice, but how many $6,000 is he going to have with a company that is losing $15,000 an year according to your example?

    Additionally, if the said business owner is making $55k while doing a $110k job. Why wouldn’t he simply go out – do what he does – and get paid the $110k without any of the trouble or headaches or risks that come with owning a business? Even if you add the $40k “profit” – that’s $95k for a $110k job. Why?

    Secondly, by under paying himself for what he does, it grossly misstates the health of the business. Under your calculation, the company is making a healthy $40k profit when in reality, it is losing $15k each year. I’d argue that a business that loses money over time is not a business at all but rather an expensive hobby. 

    I like your last statement about showing the customer what the business “really” looks like. But isn’t that what financial statements are for? Isn’t accounting created to first help entrepreneurs see the truth of their business in order to make better financial decisions? I’d like to think so.

    - Michael

  • http://twitter.com/AdrianGSimmons Adrian G. Simmons

    Dear AccountechsAZ,

    A couple small notes: (a) disregarded LLC’s should not be paying their owners a salary at all (it files a Schedule C, and the profit is subject to SE tax), and (b) the idea of “reasonable wage” is to approximate market rates (while “distributions” are supposed to represent return on investment). Which isn’t to say you can’t get away with less than the market, just that it’s not the intent of the law.

    But to the bigger picture, I’d agree with Michael that the entrepreneur’s objective is to create the greatest value possible at the lowest opportunity cost, not minimize taxes. Tax minimization only makes sense as an add-on to a successful business, not as a core element of the business strategy. If an owner can get a greater return elsewhere, he should.

    Cheers,
    Adrian

  • http://twitter.com/AccountechsAZ AccountechsAZ

    Michael, you’ve hit on an ideological difference. I define accounting slightly differently. One part of that, agreed wholeheartedly, is helping entrepreneurs see the truth of their companies. My only problem is in costing someone more tax to accomplish that. I think the point can be made another way… A way that lets them keep the money they obviously desperately need.

  • http://twitter.com/MacMcSwain Mac McSwain, CPA

    When showing LLC’s or SCorps there true profit (not tax profit) we create a line item for the distributions on internal income statements. This was we can show their total pay. I don’t think Michael is saying take all compensation as salary. He is trying to say that the true cost of compensation, including distributions, should be calculated into the bottom line. He did say the statement is “over-simplified”

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