Set compensation parameters at startup

Small-business owners may often assume that they won't earn anything until a business is firmly established. While such thinking appears logical, some experts say that if a business doesn't pay its owner a salary, the business plan and cash flow model are not being truly tested.

Unless a business operates under normal business conditions, and everyone who works for the business is compensated, it can't be determined if the business will be viable in the “real world.”

Determining the owner's salary

As a result, business owners should determine a minimum salary for themselves as early in the game as possible, preferably before operations begin. In addition, goals should be established for the business, so that owners can receive compensation that's more in line with their knowledge, skills and the time they devote to the business. It's important to review the progress of the business toward the goals every six months to make sure that compensation figures are still accurate and in line with business conditions.

Some business owners have a tough time determining what their compensation should be - and deciding one's own pay can be emotional. However, the owner is the person taking the biggest risk if the business should fail. Logically, the owner should earn more than other employees, and if that's not the case, it should be explored as to why. Is the owner making a short-term sacrifice in order to invest in future growth? It's important to understand the reasons before making a final decision.

The bonus factor

Because the cash flow of many businesses is unpredictable - especially during the early stages - owners might want to consider relying on bonuses rather than a regular salary for much of their compensation. By doing so, the owner can determine when and how much the business can afford to pay. Bonuses can come once or several times a year, depending on needs and business performance.

Taxation issues

Something else to keep in mind is how the Internal Revenue Service will view the owner's salary. For example, let's say that an individual owns a C-corporation. The “C” simply refers to the tax treatment category that the company is in. C-corporations are the most common traditional types of small businesses.

An owner may face an unreasonable compensation audit if the IRS interprets the owner's large salary as a disguised dividend. Because dividends, unlike salaries, are not deductible, an unfavorable determination could result in an overdue tax notice, back-interest charges and penalties for the business.

A good place for owners to start is talking to their certified public accountants about what the IRS would consider reasonable compensation, as well as contacts at industry associations to which the owners belong. If what the owner receives is out of line with what owners of comparable businesses receive, the owner could be setting himself up for a visit from the IRS, and costs could be substantial. Business valuation specialists also may offer some insight into what a buyer would expect to be able to take from the business.

Retirement planning

Once the owner's salary is determined, retirement savings also should be considered. The amount that can be saved in a qualified plan is calculated based on eligible compensation. Therefore, when determining compensation, it's important to keep in mind that the salary affects the amount that can be saved for retirement.

Generally, the more one earns, the more one is able to save. A financial consultant can help develop a plan to address individual retirement needs, but it's important to start as early as possible and remain consistent.

Individuals should consult with their legal and tax advisers for their specific situations.

Timothy Reese is senior vice president, investments, with A.G. Edwards & Sons Inc.[[In-content Ad]]