Determining fair compensation for family members in a family-owned business can be a bit more complicated than one might imagine. The issue of fair compensation not only involves multiple aspects of the business, but also the complexity of the family. From a business perspective, finding the appropriate level of compensation is relatively easy. There may be some bumps in the road, including possible tax pitfalls, but overall it is a very mechanical process. However, from a family perspective, there are more complex issues, including the need for achieving a sense of fairness between the different family members.
Following are some key factors to consider in determining the appropriate level of compensation among family members in the family business.
Analyze roles and compare compensation levels. The logical starting point for any compensation plan should begin with an analysis of compensation paid to employees holding the same positions and possessing the same skills within the firm and industry. Much of this data can come from several sources, including industry trade associations, job search websites and sometimes, if warranted, a compensation expert.
A fundamental question that needs to be answered is, “what would it take to replace all the job functions of the family member?” It is not always just a simple one-for-one substitution. In cases where family members take on additional roles beyond their regular duties, one might have to factor a greater than one full-time equivalent to fairly represent the individual’s total contribution to the business.
Review employment package and benefits. Once a salary range is determined, the rest of the employment package should be analyzed (e.g., healthcare and retirement plans, company cars and any other perquisites). These benefits should also be compared to company and industry trends.
The less visible, but oftentimes most valuable benefit, is the accrual of ownership. If the business is in the process of being gifted to a family member, or there is a buy-in, this should be reflected in the overall compensation package.
Tax consequences. Under certain circumstances, excess compensation may be re-characterized by the tax code as a non-deductible dividend. To the contrary, compensation that is deemed insufficient may result in penalties and interest for underpaying employment taxes. While this conundrum poses a balancing act, it is fact-specific and certainly not insurmountable.
Fairness among family members. In family business, achieving fairness among family members is one of the more difficult factors in determining reasonable compensation. For a variety of reasons, the family company may not be a calling for all of the children to participate. Therefore, a common issue of maintaining a balance of fairness often emerges. A business owner might simply want to compensate each of his or her children exactly the same, regardless of their involvement in the business. But, compensating the non-participating children through the business is problematic. Under the tax code, anyone not working in the business and/or who has no ownership interests may not receive compensation or dividends. While it might be possible to compensate a non-participating child as a board member, this approach also has limitations.
Part of the solution may be for the family members to gain an understanding that an equitable remedy does not necessarily entail that individual gifts and benefits need to be equal. An equitable approach accounts for the special needs or circumstances of each child. It is often possible to provide equitable financial treatment for the non-participating children by utilizing other areas of the family’s finances, such as equalizing shares in real estate or investments. In addition, the individual ability and aspirations of each child, coupled with the cost of education should also be considered.
We find that the key to success in any equitable remedy surrounding family business compensation is to ensure that all options are discussed in detail with the concerned family members to avoid misunderstandings or unnecessary surprises.
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