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.
The issue of executive compensation is of particular importance to heads of companies in the throes of growth. While we don't know many CEOs at billion-dollar companies who complain about their compensation, many growth-company heads -- indeed, 45% of the people responding to our survey -- thought they were underpaid. There's a good reason, of course. If your company is growing quickly, you tend to use what little money there is for new copiers, not to give yourself a raise.
But ironically, paying yourself too little can worry the outside world, too.
"Most people starting a company know nothing about a lot of things, including what they should pay themselves," says Dallas venture capitalist L. J. Sevin. "It's not a huge issue" if you should set your compensation low, "but it does show a lack of judgment.'
Sevin won't mind if you pay yourself, and your staff, a fair wage. But he -- like the IRS -- doesn't want to see overpayments, either. "We want to see companies that can attract good people without paying them a premium. That tells us the folks who sign on are committed to the idea and are motivated.'
But at some point, you'll want to be paid what you're worth. A little planning now will make that possible.
And for those who dream about the compensation of Reebok's Paul Fireman ($15.4 million), Waste Management's Phillip B. Rooney ($14.3 million), or GE's John F. Welch ($12.6 million), that planning will help you prepare your defense, in case the IRS arrives.
The factors that matter most*
A company's profitability, far more than any other factor, determines how CEO's pay themselves.
Company profitability 77%
Company revenues 43
Company's capital needs 30
Personal financial planning 23
Partners or board of directors 22
Industry norms 20
Effect on employee morale 9
Effect on top management 6
Financial-community reaction 2
*Totals exceed 100% because of multiple responses.
CEOS BEHIND THE WHEEL
The cars of choice
Among the CEO's surveyed, only Mercedes interrupts the preference for a 'made-in-the-U.S.A.' company car.
COMPENSATION FOR TOP OFFICERS BY company size*
Annual revenues CEO COO CFO CMO
$10 mil. or more $174,000 $105,000 $80,000 $71,000
$5 mil.-$9.99 mil. 145,000 71,000 51,000 75,000
$1 mil.-$4.99 mil. 105,000 69,000 45,000 67,000
Less than $1 mil. 59,000 55,000 30,000 46,000
Annual revenues CEO COO CFO CMO
$10 mil. or more $206,000 $114,000 $112,000 $95,000
$5 mil.-$9.99 mil. 126,000 72,000 73,000 67,000
$1 mil.-$4.99 mil. 100,000 60,000 41,000 56,000
Less than $1 mil. 62,000 60,000 42,000 66,000
Annual revenues CEO COO CFO CMO
$10 mil. or more $150,000 $101,000 $59,000 $87,000
$5 mil.-$9.99 mil. 142,000 ** ** 80,000
$1 mil.-$4.99 mil. 75,000 51,000 14,000 48,000
Less than $1 mil. 48,000 ** ** **
Annual revenues CEO COO CFO CMO
$10 mil. or more ** ** ** **
$5 mil.-$9.99 mil. $85,000 ** ** **
$1 mil.-$4.99 mil. 60,000 $35,000 ** $38,000
Less than $1 mil. 36,000 32,000 $13,000 28,000
*Figures rounded to the nearest thousand; ** Insufficient response for purpose of comparison
Annual revenues CEO COO CFO CMO
$10 mil. or more $181,000 $109,000 $91,000 $88,000
$5 mil.-$9.99 mil. 125,000 75,000 61,000 69,000
$1 mil.-$4.99 mil. 93,000 63,000 37,000 58,000
Less than $1 mil. 58,000 52,000 26,000 45,000
EXECUTIVE BENEFITS AND PERKS:
The benefits and perks that companies provided to their top officers
CEO COO CFO CMO
Company car & expenses 82% 65% 55% 70%
Supplemental life insurance* 64 63 60 57
Tax-return preparation 52 31 32 27
Club dues & expenses 43 27 27 27
Supplemental medical insurance* 40 40 39 38
Personal tax & financial planning 33 20 19 18
Low- or no-interest loan 25 18 19 18
Supplemental retirement benefits* 15 14 14 14
Deferred compensation 14 14 13 13
First-class air travel 11 6 6 6
Moving allowance 8 11 13 12
Among companies with at least $10 million in sales, manufacturers pay the most. But among businesses between $1 million and $10 million, it's the service sector that averages the highest in co pensation for top officers. In companies under $1 million, manufacturing is again the leader.
INSIDE THE MIND OF THE IRS
Confessions of an inquisitor
Be forewarned: if Jim Brennan shows up at your door, you're in trouble. His visit is a message, a signal that the Internal Revenue Service is ready to take you to court.
Shoveling greenbacks out of the business? Splitting your company into three different corporations, then taking a full-time chief excutive's salary from each? Or are you the frugal type, saving a few bucks by paying out profits through tax-deductible salary and bonus rather than through dividends taken from aftertax income? If the IRS thinks so and decides your offense is so flagrant it has no choice but to prosecute, it'll send in Brennan -- CEO of Brennan, Thomsen Associates Inc. and a professional compensation expert -- to show you the error of your ways, be it envy, avarice, or pride.
By law you're allowed "reasonable" compensation, "the amount that would ordinarily be paid for like services by like enterprises under like circumstances." Brennan will set a dollar figure, rationally, based on an extensive survey of like companies in like situations, and then, if necessary, he'll testify as the IRS's expert witness in court.
It is rarely necessary. Of the 60-some cases Brennan has seen in the past eight years, only 6 actually went to trial. Forty percent were settled as soon as the IRS announced it was bringing him in.
It takes a foolish taxpayer to battle the IRS much further, of course. Unlike your garden-variety felon, who is presumed innocent unless proven guilty, a CEO in tax litigation stands guilty before the first gavel falls, forced to disprove the agency's charges while facing the prospect of whopping legal fees along with the penalties and interest on the tax bill. But the IRS doesn't want to go to court any more than the taxpayer, Brennan insists. "The IRS is reasonable. They aren't given to quibbling. Usually they're more generous with the taxpayer than I could support as an expert."
The challenge is getting the taxpayer to be reasonable, too. "People let their egos get involved, and that's a trap. They feel they're being judged as deficient. They say, 'This is mine,' and feel their personal validation is threatened."
At that point reason usually flies out the window. How else to explain the taxpayers who spent thousands producing a movie showing just how vital they were to their companies, even though the judge was blind? Or how about the former fast-food fry chef who took over an adult-film company when the founder was forced to divest or face criminal prosecution, then claimed $269,000 a year (hazard pay for a job that could lead to the slammer)?
Outside the courtroom Brennan looks too good-natured to be an inquisitor. A smiling, round-faced 42-year-old with prematurely gray hair and thick glasses, he works out of a cluttered second-floor walk-up just down the mall from the Fantastic Sams haircutting franchise in suburban St. Louis. But taxpayers underestimate his reputation only at their peril. His custom-designed pay programs have been singled out for praise by Congress, the General Accounting Office, and a roster of private clients.
Brennan can predict in advance what he'll hear when the IRS calls. The company will be small, always less than $50 million in sales, usually in the $20- to $30-million range. It will be run by stockholder officers who set their own pay, in many cases meaning well, but ultimately deceiving themselves. They may believe they are "the best in the field," as one CEO pleaded, but that doesn't mean they deserve twice as much as anyone else in their industry, particularly if their company is only one-fifth the size of its competitors.
Some fall victim to "the proprietary trap," Brennan says. "They see their friends with sole proprietorships or partnerships that have drawing accounts and vacation houses, and want the same things. They think, 'By golly, this is my company. I made the money and I can do what I want with it. This is America.'
"But that's a fundamental misunderstanding of the discipline of corporations. A corporation ain't the same creature as a sole proprietorship."
Others are too generous to their children. It's unreasonable, Brennan says, for a parent in a $20-million company to pay his general counsel/son $500,000 a year while the boy is still in law school, or for another to decide his daughter is "vital and essential to the company's management" and worth $200,000 a year for flying the company plane on family vacation trips.
Equally unreasonable, and more common still, are children who are too generous to themselves -- like the cosmetology student who took a $15,600 job as secretary in her father's business, then boosted her salary to $297,500 the year after the old man retired. Brennan doesn't expect children in a family business to sacrifice like their parents did, working out of a garage, pouring body, soul, and every available nickel into the company. "But the kids want to live high right away' -- another lapse of discipline.
Brennan works blind, creating a competitive analysis of compensation in similar companies without knowing the actual salary of the taxpayer in question. Starting with sales revenue, structure, number of employees, number and title of subordinates, stock history, dividend record, profit, assets, capital, and debt, he'll turn to publicly available survey information from the Executive Compensation Service, the Conference Board, or INC.'s Executive Compensation study, looking for the closest match he can find. "I start by presuming I represent the other side -- and give them the most generous assumptions," he says. The IRS is more generous still. "They aren't interested in what's the average compensation, they want to know what's the highest anybody is paid." If you're not above that figure, you're probably safe from the court. -- Curtis Hartman
THE FACTS BEHIND THE FIGURES
This is the 10th consecutive year that Inc. has conducted an executive compensation study. In early April, we mailed a four-page questionnaire covering salaries, benefits, bonuses, and policies to a random sample of 20,000 subscribers. Data Tabulation Services Inc., of Boston and Stoneham, Mass., compiled the 1,700 usable returns.
The survey was conducted under the direction of special projects editor Sara Baer-Sinnott. Research assistance was provided by Leslie Brokaw.