S Corporation Owner Salary
S Corporation owner salary should be decided on a case by case basis. If someone suggests a standard percentage of the profits, then the advice is misguided, or just plain wrong. Salary must be reasonable given the unique situation of the business, and the kind of work performed. S Corporation owner salary must be sincere, and defensible. How much salary S corporation owners should take should be based on what the corporation would expect to pay someone else to do the same type of work, in the relevant marketplace.
S Corporation Status
Subchapter S Corporation, S Corporation, or “S Corp” status is a useful and viable corporate form in the right situations. A common area of confusion is how much salary S Corporation owners should take from their business. Actually, I find most often the confusion is really a mixture of salary at a transactional level, and really understanding separate legal entity status. Leaving aside yet another recital of Internal Revenue Code (nothing glazes eyes over like reciting IRC sections), let’s review the basics. First, keep in mind that any corporation is a separate legal entity from the owner(s). Second, if the business has revenue, and the owners do work (of any kind causing that revenue), then they must pay themselves a reasonable salary. Lastly, here is where you should leave all confusion behind. Since the IRC allows the S Corporate form, the IRS expects employees (that includes owners), that perform work, to 1) get paid, 2) have taxes withheld based on the rules, and most importantly 3) to pay their proper Social Security and Medicare taxes. If you do work, then Social Security and Medicare taxes need to be paid based on the magnitude of that payroll. Payroll is a S Corporate entity activity and responsibility.
S Corporation Profits and Losses
Aside from regular work, and the pay that goes with that work, an owner also acts as, well, an owner (shareholder). All the profit remaining, or losses, after expenses, including payroll expenses, flows through to the shareholders to be accounted for in the owners’ personal taxes. This is calculated and passed through to each S Corporate shareholder on a Schedule K1 annually (the sending of which is the S Corporations responsibility). Left-over profits are then available for shareholders to take as distributions, in accordance with their ownership percentage. Whether the owner actually takes a distribution or leaves the cash sitting in the S Corporations bank, and how distributions are taxed is another discussion. Although it is outside the scope of this blog entry, active versus passive participation, shareholder bases, as well as the character of the money taken affects taxation.
Multiples from properly selected comparable firms can support a small business valuation effort. It is especially useful used in combination with other methods. Multiples of public issuers show what price the market pays on average for those issuers. For example, let’s say an average price to earnings (P/E) multiple of 17.5 is derived for a comparable group of companies and carefully selected for comparison to the valuation of XYZ Company. The application of the multiples from the comparable group, to XYZ Company, could roll up like the following simplified (hypothetical) example:
Applying the multiple to the XYZ Company business valuation effort was not the hard part. What was more difficult was to pick the comparable firms; more difficult still, to pick public issuing comparable firms to apply to a private firm business valuation, namely XYZ Company. It was important to understand in this case that XYZ Company was driven by a relatively non-diversified product portfolio, aimed mainly at a specific industrial sector, and its original equipment manufacturer (OEM) customers. The markets for a majority of XYZ Company sales were driven by a particular product, supported by regulatory action in the utilities industry, and used in various real estate development situations, and requirements driven in part by the solar power industry.
For just such a business valuation effort we selected a group of companies in the industrial and technology sectors to evaluate as a small universe of comparable firms, and listed the various manufacturing industries from these sectors. These sectors were selected to match XYZ Company’s sector and industry classification and manufacturing industry types, and for all firms exposed to selling components into OEM systems. We also use comparable firms that match the capital structure and risk profile, while focusing on companies where data is available publicly, unless we have true inside access to comparable private firms.
This data was then compiled in complete detail in a matrix, using pre-selected criteria, as given in the example below. We then evaluated which of these firms met a majority of the criteria, and that more closely matched asset and policy structure of XYZ Company. The technical problems encountered to normalize larger or more diverse public firms to a smaller private firm we leave for another posting.
Further analysis led to selection of firms to use as comparable firms for price versus earnings, to derive P/E ratio in a matrix with the pre-selected criteria, as shown below. The resulting multiples used to project onto XYS Company’s actual and forecasted earnings per share. The purpose of this was to value XYZ Company, and straddle the XYZ Company valuation with the comparable firms’ multiples that are over or under valued by the markets. We further compared the resulting XYZ Company multiples valuation to the free cash flow to operations analysis performed in the same effort.
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According to the Census Bureau, NAISC 334510 Electromedical and Electrotherapeutic Apparatus Manufacturing is a diverse and important industry classification comprised of thousands of companies producing medical devices and related products in at least 53 categories or index entries. The North American Industry Classification System and the Census research behind it are free and available at http://www.census.gov/cgi-bin/sssd/naics/naicsrch. Public issuers (companies selling securities to the public to gain access to capital) are required to submit financial reports to the SEC, and given the high value of the notes to those financial statements and the scrutiny under which they are viewed is a very valuable source of data for market analysis. SEC data can be accessed through Edgar, at http://www.sec.gov/edgar/searchedgar/companysearch.html. Medical device research, science, medical peer publications, FDA reporting, and other materials on this specific industry can also be had at the
National Center for Biotechnology Information (databases accessed there are numerous) at http://www.ncbi.nlm.nih.gov/. Biomedical literature is also available from http://www.ncbi.nlm.nih.gov/pubmed, MEDLINE, life science journals, and online books, and https://www.nlm.nih.gov/pubs/factsheets/medline.html is a bibliographic database on life sciences and biomedicine. Keep in mind that US Citizens’ taxes pay for a wide array of services, data, and information, many sources of which are overlooked by the average person or small business. The list of free public sources of data is almost unlimited. The reason I bring this up is to simply point out that market analysis for any given industry starts with a basic mindset, of knowing what data you can get, from what source, what is “fact” versus what is subjective, hearsay, or anecdotal, and whether that information is reliable for your purpose. Firms selling standardized market analysis reports to SMBs, or large corporations and users for that matter, do a wildly varying level or quality of work, in my opinion, and sell those reports for a range of prices. Sometimes, ridiculous prices for generalized information. The mark of a better report or analysis effort is generally to what extent the creator took care in gathering its data, referencing the source of that data, when and to what extent they are making assertions or assumptions about that data, telling you clearly the difference between fact and conjecture, and yet most importantly answering your real questions as a potential user. For example, if I sold you a report on the Medical Device industry that informs you of the size, direction, and growth of the overall industry, based on good statistics, involving many supporting industry participant interviews, and good verification of what I a purport to be factual, would that do you any good? Not if your purpose was to know how 1/53 of that industry group operates, exactly what products they make, who is involved outside North America, what the value proposition of those products is, and how you can compete. And very likely not useful if it is still too general and does not tell what are your prospects, is not designed to your purpose specifically, is not designed to provide decision-making information to you, and does not support your key questions. To that end, before you pay money, you will find there is a wealth of information and generalized market analysis reports (and fairly good ones) available for free, or at a reasonable cost through libraries, the web, or your local university library. This may be a good place to start in order to first understand the landscape. Collecting data from public web sources, even from prospects or competitors themselves can be valuable and free information, with just the burden of knowing what value to place on that information and how it can be biased. Even a source providing biased information can provide valuable inputs if looked at with the right perspective, to answer purposeful questions.
© 2016 Worldview Consulting & Accounting, Inc. All Rights Reserved.