Pay Structure

An owner who runs a business holds two positions in it. They work there, often as the general manager and as the person who wins or prices the work. They also own it, so their capital is at risk and they are entitled to whatever remains once everyone who works there has been paid. The work earns a wage and the ownership earns a return. Those are different claims on the business, and they call for different payments.

Most owner-run businesses pay both claims out of one stream of cash. The previous driver, Owner Pay, makes that stream visible. Pay Structure sorts it into its parts. It pays the owner in the form the business's tax status requires, files payroll for any owner salary, lists every benefit paid for the owner with its tax treatment, and documents one market-rate salary for the work the owner does. After that, a buyer can see that the pay was lawful and properly taxed, and what the owner's job would cost to fill.

The form the tax status requires

Owner pay has to take the form the entity's tax classification requires. The classification is confirmed from the latest return and the election on file. Every payment to the owner in the latest year is recorded in the required form, payroll filings for any owner salary are current, and any earlier shortfall has been quantified with the outside accountant and either corrected or disclosed.

What the required form is depends on how the business is taxed. In the United States, a sole proprietor's draws are withdrawals of the owner's equity. A partner's pay for the work they do is booked as guaranteed payments. An owner of an S corporation who works in the business is expected to take a reasonable salary through payroll before taking distributions. Other countries draw the same lines in their own ways, and the principle holds under whatever the local equivalent rule is.

One error a buyer's diligence looks for specifically is an S corporation owner who takes only distributions and no salary. Distributions are not subject to payroll tax, so the owner pays less tax each year, and the shortfall can go unnoticed for a long time. A buyer's diligence team will find it in an afternoon. The unpaid tax, with penalties and interest, then comes off the price or is held back at closing until the exposure is settled, and the buyer may also ask for an indemnity against anything not yet found.

What the owner gains by settling this first is certainty. Once the exposure has been corrected, or quantified and disclosed, the buyer can price a known number once and move on. An exposure the buyer finds for themselves gets priced at its worst.

Two habits get the business there. The outside accountant confirms the classification, and the form of pay it requires, in writing, citing the latest return and the election on file, so the business's understanding of its own tax status rests on a document. Without one it rests on what the owner remembers deciding years ago. And any owner salary runs through the same payroll as the staff, with withholding and filings, on the date Owner Pay sets for the draw. An owner paid outside payroll has wages that exist only in their own records.

A market salary for the owner's seat

The second piece of work is one market-rate salary for the work the owner does, documented once, from a named compensation survey for the region and company size, dated and with its source.

The figure gets used three times. It supports the reasonable salary the tax rules require of an S corporation owner. It is the owner salary the valuation at the end of the bridge deducts when it works out what the business earns for an owner who no longer does the work. And it is the starting figure on the next bridge, where every seat in the organization is priced in turn.

A buyer who will hire someone for the owner's job has to decide what that person will cost. Without evidence they will use their own estimate, and it will be generous to themselves, which shrinks the earnings they are willing to pay for. A salary with a named, dated source changes the conversation. The buyer can still disagree, but now they need evidence of their own to do it.

The seat is priced from two sources, a published compensation survey and a recruiter's quote, and the figure used and the reason for choosing it are recorded. A second source guards against a survey that does not quite fit the role, and the recorded reason means someone other than the person who chose the figure can defend it.

How much of the profit was profit

The market salary also tells the owner something about their own business: how much of its profit was ever profit at all.

Some small businesses report a profit only because the owner works for less than the job is worth. Pay a hired manager the market rate for the owner's seat and the profit shrinks, sometimes to nothing. In those businesses the owner earns little or no return on capital; they subsidize the business with underpaid labour and call the subsidy profit. In the early years, when cash is better left in the business, that can be a sensible choice. It is better made with the number in view.

The illustration shows how much rides on it. A business earns $180,000 a year before paying its owner anything, and the owner's seat would cost $140,000 to fill. A buyer who means to run the business personally is buying a job and an investment together and looks at the whole $180,000; at an illustrative multiple of two and a half times, the business is worth about $450,000 to them. A buyer who will not work in it has to pay the manager first, which leaves $40,000 a year for ownership. Capitalized at an illustrative 25 percent return, that is worth about $160,000.

Both values come from one business, one year and one set of records. The $290,000 between them is the value of the owner's labour, and it goes with whoever supplies that labour. An owner who hopes to sell to anyone other than another owner-operator has to show what the seat costs and whether the business still earns something once the seat is paid for, and they cannot show either without a documented market salary.

Every benefit, listed

Alongside the salary sits a list of every benefit the business pays for the owner, each with the account it is coded to and its tax treatment: health insurance, retirement contributions, a vehicle, a phone. Each is recorded as wages, as a benefit or as a distribution.

Benefits are where the owner's pay and the business's costs blur most easily. A vehicle used partly for the business and partly for the family, or a phone plan that covers the household, is part of the owner's compensation, and a buyer needs to know its size and treatment to rebuild the owner's pay accurately. A benefit coded as a business expense when it was really pay to the owner understates the owner's compensation, and the adjustment to correct it will be accepted only if the record supports it.

What has to be in place first

Two conditions come first. The owner compensation and benefit accounts set up under Owner Pay have to exist, because pay can be tested for its form only once it sits on its own lines. And an outside accountant has to be engaged for the classification and the payroll filings. The owner and whoever runs the crossing should not settle the business's tax status between themselves, because neither of them will be the one answering for it.

Knowing that it works

The pay record is the months of owner pay in the required form, out of the latest year, set beside the number of late payroll filings for owner salary, with a target of none.

The check that can be put to the owner is to say how the business is taxed and how that rule shapes their pay, and to give the market salary for their seat with its source. An owner who can do that has pay a buyer can read. An owner who cannot has left the buyer a reconstruction to do, and the buyer will do it conservatively.

Why it slips, and what holds it

The drift to guard against is owner pay slipping out of the form the tax status requires. It usually follows a change: the business elects a different tax status, takes on a partner or restructures, and nobody connects the change to how the owner is paid. The outside accountant reviews the owner's pay against the tax status at each year end, and again whenever the election changes, so the drift is caught before a return is filed on it.