As businesses grow and mature, compensation strategies often become complex, especially when new owners join or founders plan to step back.

What begins as a simple system can quickly become misaligned, creating tension and inefficiencies. This is especially true of companies set up as S corporations.

As companies contemplate adding additional shareholders, a deeper look at wages is appropriate.

S corps

When setting up an operating company, many such companies are set up as S corporations, which are defined by their tax status rather than legal status.

Indeed, either an LLC (limited liability company) or a corporation can choose to be taxed as an S corporation. And initially it might make a lot of sense to do so. That form of taxation for the business can help the business owner save on things like payroll taxes and corporate level taxation. But those decisions also have downstream effects that can thwart a long-term vision for the company.

The setup

Here's a typical example. Assume John starts a construction company, ABC LLC, and chooses S corporation taxation. Since John is the only owner and can take compensation in two forms (wages and C corporation distributions), he may wisely choose to take less in wages and more in distributions.

Assume John pays himself $50K in wages and $50K in S corporation distributions when he might very reasonably be paid a wage of $100K (and no distributions) if he worked for a different company other than his own.

The rationale for this is payroll tax savings. So, he might be said to artificially deflate his wages (customarily paid for effort) and concurrently artificially increase his S corporation distributions (customarily recognizing the success of the company).

While his compensation approach is effective early on, it can create challenges when ownership expands.

John has another worker in his company, Julie. She gets paid $50K as well, but her pay is reasonable for both her effort and her contributions to the company’s bottom line.

Assume Julie pays for herself without adding additional profit to the company. John is OK with this as he is not out anything by employing her, but neither does he make money off her.   

The dilemma

Assume John plans to offer equity ownership of ABC LLC to Julie. John sees Julie as a great successor to his business, and the option for ownership could entice her to stick around. But Julie also wants a work-life balance that John has never contemplated.

John puts in long hours and plans to continue putting in long hours even after he transfers half the company to Julie (by sale, bonus or some other arrangement). She plans to continue her effort at the same level.

After the transaction granting Julie 50% of the company and her promise to continue to work, John gets frustrated because he is working more than she is.

Yet, he only makes $50K and splits all the remaining profits with her. Regrettably S corporation distribution payments are not like wages that are paid for effort – the money goes to owners in proportion to ownership, whether the person works or not.

One practical solution

To compensate John fairly, he should consider changing his compensation to reflect effort. That is, he should increase his wages despite knowing he will pay more in payroll tax.

For example, if he increased his wages to $100K and maintained Julie’s wages at $50K, he could then split additional profits with her after paying the appropriate employee compensation.

The immediate effect based on this hypothetical situation is that neither Julie nor John receive any distribution. But, as the company grows or Julie increases her effort, additional profits could then be split proportionally between the owners while still adequately compensating John for his heavy workload.

Plan ahead

Of course, there are many other ways to address this planning challenge.

More than anything, this identifies a common problem and highlights a simplistic solution. The more appropriate solution is to work with your planning team to determine how best to accommodate new ownership.

Beau Ruff is an attorney and director of planning at Cornerstone Wealth Strategies, headquartered in Washington state and servicing clients nationwide.