Dealer Insights - Nov/Dec 2012 - Compensation Matters: Determining Your Own Pay
November 01, 2012
Do you feel that your business is back on track after the recession? If your new car sales have put a smile back on your face and your used car and service departments are merrily humming along, you might think now’s the time to give yourself a hefty and overdue pay increase.
But before you compensate yourself for all you believe you deserve, take stock: The IRS is in the business of scrutinizing top executives’ salaries, bonuses and distributions or dividends. Various stakeholders also may be examining your self-compensation decisions. Here are some factors to consider before setting your new pay.
WHAT’S THE RIGHT BALANCE?
Let’s start with the basics. Your compensation is affected by the amount of cash in your dealership’s bank account. But just because your financial statements report a profit, it doesn’t necessarily mean you’ll have cash available to pay owner-employees a higher salary or large bonus or make annual distributions. Net income and cash flows aren’t synonymous.
Other business objectives — such as buying new equipment, repaying debt and sprucing up your showroom — vie for your kitty. So, it’s a balancing act between owner-employees’ compensation on the one hand and capital expenditures, expansion plans and financing goals on the other.
WHAT IF YOU’RE A C CORPORATION?
If you operate as a C corporation, your dealership’s income is taxed twice. First, it’s taxed at the corporate level. Then it’s taxed again at the personal level as you draw dividends — an obvious disadvantage to those owning this corporation type.
C corporation owner-employees might be tempted to classify all the money they take out as salaries and bonuses, which the company can deduct, to avoid the double tax on dividends. But the IRS is wise to this strategy: It’s on the lookout for excessive compensation to owner-employees and may reclassify above-market compensation as dividends, potentially resulting in additional income tax as well as interest and penalties.
The IRS also monitors a C corporation’s accumulated earnings. Generally similar to retained earnings on your balance sheet, accumulated earnings measure the buildup of undistributed earnings. If these earnings get too high and can’t be justified for such things as a planned expansion, the IRS may assess a tax on them.
WHAT ABOUT S CORPORATIONS?
S corporations, limited liability companies and partnerships are examples of flow-through entities, which aren’t taxed at the entity level. Instead, income flows through to the owners’ personal tax returns, where it’s taxed at the individual level.
Dividends (typically called “distributions” for flow-through entities) are tax-free to the extent that an owner has tax basis in the business. Simply put, basis is a function of capital contributions, net income and owners’ distributions. Distributions in excess of basis are subject to ordinary income tax, but they’re not subject to payroll taxes.
So, the IRS has the opposite concern with flow-through entities: Agents are watchful of owner-employees who underpay themselves to minimize payroll taxes. If the IRS thinks you’re downplaying salary in favor of payroll-tax-free distributions, it may reclassify some of your distributions as salary. In turn, while your income taxes won’t change, you’ll owe more in payroll taxes — plus interest and penalties, potentially.
DO YOU REFLECT THE MARKET?
Above- or below-market compensation raises a red flag to the IRS, and that’s definitely undesirable. Not only will the agency evaluate your compensation expense — possibly imposing extra taxes, penalties and interest — but a zealous IRS agent might turn up other challenges to your records.
What’s more, it might cause a domino effect, drawing attention in the states where you do business. Many state and local governments face budget shortages and are hot on the trail of the owner-employee compensation issue.
WHO ELSE MIGHT BE CONCERNED?
Other parties may have a vested interest in how much you’re getting paid, too. Lenders, franchisors and minority shareholders might think you’re impairing future growth by paying yourself too much.
If a silent owner, factory representative or lender, for instance, decides your showroom looks shabby and sees flat sales, your salary expense and dividends might become the subject of debate. (Also see the sidebar “Here comes the judge!”)
AVOID HOT WATER
One of the major advantages of being a dealership owner is having a big say in all manner of decisions. But when it comes to your compensation, make sure you’re being prudent. Otherwise, you may find yourself in hot water with the IRS and others who have an interest in your business.
SIDEBAR: HERE COMES THE JUDGE!
If you or your dealership is involved in a lawsuit, the courts might impute reasonable (or replacement) compensation expense. This is common in divorces and minority shareholder disputes. The amount the court prescribes for your compensation affects business value, which, in turn, affects damages awards and asset distributions. In divorce, reasonable compensation also affects child support and alimony awards.
When a court imputes reasonable compensation, it typically considers compensation studies and other factors — including your salary history, responsibilities, experience, geographic location and dealership’s performance.
Dealer Insights - November/December 2012 Issue