How CEOs can maintain a high salary while keeping investors, bankers, and the taxman content.
How to take down the big bucks -- while keeping investors,bankers, and the taxman smiling
Charles Lazarus of Toys 'R' Us Made $60 million last year. Jim P. Manzi of Lotus raked in $26.3 million, and wine maker and author Lee Iacocca found a total of $17.9 million coming his way.
You work just as hard running your company as they do running theirs. So you should make that kind of money, too -- right?
Well . . .
OK, you decide you can live with just a fraction of what these guys find in their pay envelope each week. But exactly how large should that fraction be?
That's the question facing people who run their own companies, and unfortunately there is no terrific answer.
Surely, if you pay yourself $4 million a year and your company grosses only $3 million, you're going to raise some eyebrows -- your banker's, your stockholders', your venture financier's.
You'll also probably discover that the IRS wants to chat.
The government's position on paying yourself too much is simple. If you got $500,000 last year for a job that was only worth $125,000, the Internal Revenue Service is going to treat the "extra" $375,000 as a dividend. This, for the feds, is better than discovering that Christmas comes twice a year. You -- as an employee -- are going to pay personal income tax on that $375,000. Plus, your company won't be allowed to deduct the $375,000 as a business expense. Salaries are deductible. Dividends ain't. If ever you wanted to make a case for eliminating the corporate income tax, this would be it. As the example shows, the same income is being taxed twice, once when the corporation makes a profit and again when that profit is received as salary.
But the friendly folks at the IRS aren't overly concerned about tax theory. They're worried about you living too high off the hog. Their official position is this: you can pay yourself a nice salary, as long as it is "reasonable compensation" for the work done.
The problem with that is obvious, says Ronald Neill, a partner at Calfee, Halter & Griswold, a Cleveland law firm. "Reasonableness, like beauty, is in the eye of the beholder."
Swell. But all is not lost. Compensation experts say the following approach to writing your own ticket will keep the IRS at bay.
Step 1: Look around. The most important thing, they say, is to determine what your peers are getting. If you're running a $5-million toy company, find out what people who are running similar-size toy companies -- not Toys 'R' Us -- are getting. Then try to stay in the ballpark. While your competitors are not likely to turn over their W-2s, trade publications and associations probably do surveys that will let you know what they make.
Step 2: Leave a paper trail. Having set your salary, be sure to spell out in writing how that decision was made -- and have somebody at arm's length approve it.
"The IRS doesn't want to take on a company's board of directors," says Arthur F. Farwell III, vice-president at The Johnson Cos., a management-compensation and benefits firm in Langhorne, Pa. "If the board has reviewed the plan, then the company has a stronger case" when the IRS comes to call.
Step 3: Plan ahead. Set your compensation plan early in the year. If you wait until December to come up with a way to dispose of that extra $375,000 the company finds on hand, the IRS is likely to say it isn't a bonus, but a dividend.
"It isn't so much the semantics as having a reasonable program," says Farwell. "If the track record has been to pay out 20% of profits each year, and you suddenly find yourself with a hot product that makes that 20% a huge number, you are probably OK. But if you normally pay out 5% and this year it's 63%, that's trouble. There's no consistency."
The bonus as a percentage of sales or earnings, by the way, is one way the big-company boys pull down the serious bread. Charles Lazarus's base salary is "just" $315,000. But his contract provides an incentive bonus of 1% of corporate pretax profits over $18 million. That came to $3.2 million last year. (Stock options made up the rest of the $60 million.)
If you follow our three-step approach, your salary is likely to pass IRS muster, even if it suddenly jumps from $60,000 to $200,000. In such a case, says attorney Neill, you could argue that compared with other executives in your field, you were underpaid at $60,000. You could also say that a good hunk of that compensation came in the form of incentive compensation, which was set in advance and agreed to by your independent board of directors.
Still baffled about how much you should be paid? Ask your banker. If you're running a $5-million company that's making 10% pretax, the subject of your salary may not even come up when your company applies for a loan, says Jack Leahy, a vice-president at Chase Manhattan Bank, in New York City. "But say that company is only making $40,000. Then one of the things we're going to look at is what the entrepreneur is paying himself," he says. "If the chairman is taking out $400,000, then obviously the company has some flexibility on the number it brings to the bottom line. In this case, we may set a limit on what the salary should be." That limit won't be expressed in terms such as reasonable compensation. The bank will talk numbers -- stipulating that pay is "not to exceed $100,000," for instance. If you pay yourself more, they'll call the loan.
And if you are thinking about getting around either your banker or the IRS by taking less salary but making it up in fringes, think again. While you may have gotten away with it in the past, you no longer will. Now, there's a whole series of tests used by the IRS that prevents you from favoring yourself in fringe-benefit plans. What you give yourself, you have to give to all your employees.
