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How does a salary of an shareholder (who is also President/Owner in the company) get determined for a small business

Example situation:

  • Owner of Company: owns 90% stake
  • Investor in Company: owns 10% stake
  • Company makes $300,000 in profit at the end of the year

Can Owner of Company set his salary to $300,000 effectively making profit of $0?

Follow up questions:

  1. How is a "fair" salary determined in relation to profitability where "fair" means future investors would feel comfortable investing
  2. Under what circumstances would it be possible for shareholder to request salary information and profitability information from the Owner
  • 3
    They could, but then nobody'd want to invest in them anymore. – Joe Z. Mar 28 '15 at 2:46
  • Do you mean revenue or profit for the last point? If the revenue is $300,000 then what are the costs of goods and other business costs being covered here? – JB King Mar 28 '15 at 3:17
  • @JBKing good catch :) I did mean profit (after employee salaries & cost of goods & other business expenses). You can tell I'm a newbie :P – Toli Mar 28 '15 at 3:22
  • @JoeZ. How is a "fair" salary determined (one that other investors would feel comfortable with) – Toli Mar 28 '15 at 3:24
6

The first rule I follow is pretty simple:

Get paid for what you do. Earn a return on what you own.

If you are running your company prudently, you should earn a salary for the position and responsibilities you hold within the business. This salary should be competitive. You should be able to replace yourself in the business at this salary. If your title is "President" or "CEO" - look for market rate salaries for others in that position within your industry and company size. If you wear multiple hats in a small business, you will likely have to blend this salary based on those various positions.

Based on how you run your business, the money left over at the end of the year after you and your team takes a competitive wage is your profit. If there isn't any profit, then you might want to do some work on your business model. But if their is a profit, then it's a clear return on what you own and not just a payment for work completed. The idea would be that you could exit the business as an operator, pay someone else to do exactly what you do, and you would continue to get that profit return at the end of the year. This is when a business acts like a true asset.

Whether you take your money in salary or profit distributions (or dividends) depending on your structure, taxes are about the same. W2'd salaries get normal employee contributed taxes, but then of course the company matches these. It is identical if you take a guaranteed payment or distribution that gets hit with self employment taxes. Profits are also going to get hit with the same taxes.

Follow ups:

1) A fair salary would be a competitive market wage for the position you hold within the business. What is left over would be considered true profits and not just fabricated profits by taking a lower than market wage to boost the appearance of profitability.

2) Shareholders requesting salary information would be covered in your Operating Agreement or Shareholder Agreement. This might be terms you set with your investors. Or you might simply set a term that you only need approval if a single salary exceeds a cap (like $250,000). Which would mean you would need to present why you deserve a higher salary and have your board approve (if you are governed by said board via your investors). Profitability is a different ballpark. Your investors most likely have a right to see a monthly, quarterly, and/or annual Profit & Loss statement which should clearly state profitability. I can't imagine running a completely closed book company to my investors. Actually... I can't really imagine ever investing in a company where I am not permitted to see the financials.

Something to also consider here is the threat of trying to keep your profit numbers low in order to not pay taxes or to pay yourself a higher salary. If you ever plan to sell or exit the company, most widely accepted valuations of a business are done from profits (or EBIDTA). You might think you are saving yourself a couple points on taxes by avoiding profits in the short term, but if you exit the business and get a 3-5X (or even up to 12X in some cases) multiplier on your annual profits, you might be kicking yourself for trying to hide them through your accounting practices. Buyers will often sniff out an owner who created false profits by not paying themselves, but what's harder to do is figure out how much profits should have been when there were none on the books. By saving yourself $100,000 in taxes this year, could add up to close to $1,000,000 in an acquisition.

Good luck.

2

A combination of market research and tax law would likely be the combination used to set the salary. An elaboration of each:

  1. Taxes - In Canada and the US there can be differences in how payments are treated if they are salary,e.g. payroll taxes such as CPP, Social Security and others may apply in this case as well as personal income tax rates, or dividends, which may have different treatments in some jurisdictions I believe. If salary above $250,000 is taxed at 40% and dividends are taxed at 15%, which rate would you rather pay? (This is hypothetical as no jurisdiction has been noted here yet.) Most provinces and states in North America will tax the first few dollars at rather low rates and so it isn't bad to take a nominal rate of $1 or so in salary as usually the higher rates exist for higher salaries. Executive Compensation has come under scrutiny in recent years though it is usually a mix of salary, bonuses, and stock either restricted or options.

  2. Market Research - Some companies may research what other small public companies would pay executives as the salary may have to be approved by a board of directors in some cases. At least this would be how I remember things being decided in small companies I worked for in Washington State and the province of Alberta.

In a lot of company cases, excess earnings are stored and if there is enough of a pile then a special dividend may be given out though some corporate structures like REITs force dividends to maintain their tax status.


Note the payment in dividend here requires that the President be able to dictate what happens with the cash in the bank of a company which isn't going to be the case for the regular employee. Also, the dividends here would go to all the shareholders and thus if there are people besides the President owning shares they would also get their portion based on what they own.

  • I think only capital gains from stocks are taxed at 15%, not dividends. – Joe Z. Mar 28 '15 at 3:42
  • 1. Taxes: In that case why do company owners not pay themselves entirely in dividend (ex: Jack owns 100% of company that makes a profit of $100,000. instead of giving himself a salary of $100,000, he sets it at $1, and has the company issue him $99,999 in dividend for that year taxed @ 15%) – Toli Mar 28 '15 at 3:42
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    Some CEO's of large companies do exactly this - look up "dollar-a-year men", or one-dollar salary on Wikipedia. – Joe Z. Mar 28 '15 at 3:44
  • @JoeZ. interesting. Is there a limitation/any "side effects" to being compensated entirely in dividend? It seems a little too good to be true. Why don't "normal" employees (non executives) opt to me compensated in dividend? – Toli Mar 28 '15 at 3:55
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    There's a high risk involved there, I think. Tech companies usually get stock options, which allow them to get compensated in dividend, but more traditional jobs usually won't have this option. – Joe Z. Mar 28 '15 at 4:00

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