Here’s the question I got today in email:
I recently started a business with four others. Modest revenue has begun and two of the partners want to draw compensation. What is the trade off for them drawing compensation while others do not?
The question reminds me that a lot of people confuse getting paid for your work with making a return on an investment. Although the principles involved are plain and clear, tax treatments are anything but, so accountants and attorneys matter. So hold that thought for a bit. Let’s stick with the main points here.
All businesses should pay all employees fairly for their work and fairness is usually a matter of market value. A programmer might earn $40 per hour while a data entry clerk gets $20 per hour. Most jobs fit into some kind of categories and people either know or find out how much other companies are paying for equivalent jobs in an equivalent market.
Ownership ought not to make any difference. Businesses should treat owners who work as employees, and pay them fairly for their work. I mean legally and practically. Tax law wants owners who work in the business to be employees, and owners who don’t work in the business to not be employees. From the point of view of tax law, owners who work should earn salaries and the government gets taxes from both sides, from the business as employer and from the owner-employee as employee. On the other hand, money the business pays to owners who don’t work should be dividends, not compensation, and dividends get taxed differently. So the basic principle is that compensation is for people who work, according to the work.
Think of the meaning of the word and phrase: compensation and return on investment.
Aside from tax problems, mixing ownership return with compensation also fouls up the basic business numbers. If owners take wages for nothing then expenses are overstated and profits understated. If owners work for free and live off profits, or draw, then expenses are understated and profits overstated. Disguising business reality is not good.
In business plan context, I always recommend that the numbers include treating working owners as employees. Their compensation goes in the personnel plan along with that of all the other workers. Getting paid from profits may have tax advantages in some special cases, but it’s bad analysis. It clouds the real nature of the business.
So in your case, I can’t answer your question directly because you left out some critical information. Are the two partners who want to draw compensation working in the business? Are the two who don’t want that not working in the business? I think you can probably guess my answer. Pay any and all partners who work in the business a fair wage for the work they do, based on market value. And don’t pay those who don’t work. Then, at the end of the year, when the months close and all expenses are paid, the four owners take their share of the profits as draw, or not, or reinvest it in the business, or whatever. At least at that point the terms are clear, and what is left over after expenses is profits. Owners share profits according to their share of ownership.
Now, after all that as plain and simple principles, it wouldn’t be fair for me to not add that in some cases the intricacies of tax law determine some weird or twisted variations. For example, it’s quite common for sole proprietors in very small businesses to take regular draws from the business, but not treat themselves as employee. In that case it’s usually a tax-related alternate universe. And there are lots of other strange variations.
I say keep it simple in principle but expect to go over the details with either your attorney or accountant, or both. Just don’t lose site of that important fundamental principle that the business pays people who work, and profits for owners come from what’s left over after all the costs and expenses have been paid.
Tim Berry is the founder and chairman of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry.
