Seven Principles of Compensation for the Family Business

by David Hawkes, of Counsel, Runyon Kersteen Ouellette, CPA's

January 15, 2003

The subject of compensation for family business members can be a very sensitive topic and, if fact, is usually the most sensitive topic. Here I will present “the Eight Principles of Family Compensation. It is important to note that the author by profession and by personal experience has at least two biases, which need to be pointed out. First, the author spent most of this career as a tax professional and hence several of the “principles” have their root in the quest of saving taxes for the Family. Second, the author always personally worked for organizations that had predominantly merit pay systems and is an advocate of such systems.

The topic of family business compensation is so sensitive that the application of any of the principles or a combination of the principles has to be very carefully communicated to all those affected. The secret application of these principles is not recommended.

PRINCIPLE ONE Pay Young Family Members Extravagantly

Young members of the family are or can be “tax shelters”. They can receive earned income of several thousand dollars per year tax-free and the family business receives a tax deduction for these payments.. This tax fact allows such family members to be paid especially well for summer jobs while a student. The best procedure for such pay is during the summer pay the family member the same as other summer workers and then at year-end make a lump sum payment to further compensate the family member. That payment could be purposefully set aside in a college fund and continue to be added to as further summers are worked. If the family member starts summer employment at, say age 14, there could be as many as 8- summers to employ this arrangement-- more if graduate school was involved. It is essential that the family member actually work and depending on the business such “work” could include assignments even while away at school. The rationale for the higher pay is simply that the family member is in training to become a key manager in the business and, as a member of the family, has inherent loyalty and a sense of responsibility beyond that of a non-family member at the same age.

A variation on this theme is to elect to the board of directors or advisory board family members when they reach age 18. Service on such boards should be compensated at the same rate as for non-family members on the same board. Travel expenses to and from board meetings can be paid for the family members if such expenses are also paid for non-family board members.

As with most income tax strategies there are exceptions. For the family of average means who may qualify for financial aid accumulating funds in a student’s name may be counterproductive as such funds would be counted more heavily in reducing a financial aid award than if the funds were held by the parents. Further, education funding obligation occasioned by a divorce could also complicate any separate funding through the family business.

This strategy gets more complicated if the family business is owned by more than one branch of the family. It can still work it just takes a little more process. For instance, if two brothers own and manage the business and one has children and the other does not the one whose children benefit from the “extra pay” should have reduce his pay or some economic benefit (at the after tax cost to the business) to make this all fair (My experience is that when the brother with the children offers to reduce his pay it is usually declined by the other brother. It was the offer that counted)

PRINCIPLE TWO Base Compensation for Family Members Should Always Be “Marked to Market”

Base.Compensation for members of a family of the same generation is where most problems occur. The usual systems are equal pay for members of the same generation or compensation based upon the fair market value for the position. These are the extremes and there can be variations in the middle.

This principle of “mark to market” takes away issues of significant differences of business responsibility between members of the same generation it, however presumes that at each position in which a family member is employed that the family member adequately performs. The failure of performance is a whole other topic.

The equal pay system usually arises as a second generation comes into the family business. Dad and/or mom are used to treating children equally so it seems natural and “right” to pay all the children the same regardless of their position or their educational and other business experience. “Equal and right” may seem appropriate to dad and/or mom but the children and, unfortunately, usually their spouses over time may not see it that way. A kind of creeping irritation can occur and without being addressed can destroy all the good things about working in a family business. This usually happens after dad and/or mom are no longer in control of the business. It sometimes is part of the process of deciding who “gets dad/or mom’s office”.

Market compensation can seem difficult to determine but there is almost always a way to fairly and accurately make the determination.. If the family business has a non-family member or members on the board it could be those individuals who are asked to make a recommendation or determination of the market value for each position in the business held by a family member. The outside board members should be given the privilege of obtaining information from the firm’s accounting firm or from other sources of such information

PRINCIPLE THREE It is Sometime Ok to Pay “Family Compensation”

Family compensation is simply money paid in the form of compensation just because a person is part of the family that owns the business. Principle One could be called “Family Compensation”. Family compensation is logically only a factor when the overall system of family compensation is “mark to market.” Family compensation if, paid, is almost always an equal amount of money to each member of a generation with no tie to longevity or performance. Here again the motive is usually income or estate tax related. (Moving money to lower income tax brackets or to the estates of younger family members.) The family members receiving this family compensation should be cautioned to set it aside and not use it to elevate their standard of living. This can be hard to accomplish. One significant Maine Family accomplished this by having the family members place the after tax family compensation in a family partnership managed by the senior family member. That family partnership made securities investments and otherwise kept the money from elevating some or all the styles of life of the younger generation.

It is also important to communicate to the recipients of family compensation that if the company gets in trouble this money may be the first to go.

PRINCIPLE FOUR An Incentive Compensation Plan Should Always be Based Upon the The Business’s Strategic and Marketing Plans

Principles ONE through THREE relate either to base compensation or money paid to family members because they are family members. Principle Four relates to money available beyond base compensation.

Every business, family owned or owned broadly owned, should have a strategic plan. There is no time in the life of an enterprise when this has been truer than now. The difficulty is first to set aside the time, energy and money that it takes to effectively plan and then to implement the plan action steps, in part, with a marketing plan and a compensation plan that provides an incentive in money to the team and individuals who help make the strategic goals a reality. Here is not the place to advocate further for the process of strategic planning but suffice it to say that any incentive compensation plan not serving a carefully thought through strategic plan will not be very effective.

Incentive compensation in a family business should be for all members of management not just family members. In some situations the incentive compensation plan can effectively include staff at levels well below management. It all depends on the business goals and the identification of who can help in the realization of those goals.

PRINCIPLE FIVE An Incentive Compensation Plan Should Be Written, Have Easily Understood Goals with Payments Based upon a Percentage of Base Compensation

Action
The topic of incentive compensation plans has found its way into many books, articles and speeches on the subject. For the purpose of this principle I will just note that any incentive compensation plan needs to be well communicated and, of course, as such should be written and distributed to those covered by the plan. It should contain enterprise goals and goals for individuals. The enterprise goal could be as simple as meeting budgeting net income with the result that all employees in the plan receive a payment of 5% of their base compensation. It can be more complicated to include features such as if budgeted net income is exceeded by say, 50%, then all covered employees receive a payment of, for instance, 10% of their base pay. The enterprise goals reward the team and sometimes that is not enough to fully incent individuals to make the extra effort to realize all the business’s strategic goals. For instance, if one of the strategic goals is to acquire a competing business and one person in the management team is assigned that responsibility that person may have as an individual part of his/her incentive compensation for that year the possibility of a, for instance 25% of base compensation payment.

PRINCIPLE SIX Pay Retiring Family Members Modestly

This principle has its root in estate planning strategy. It is directed to the situations where the senior family members have such significant net worth and liquid assets that there is no issue of independent of their compensation of not being able to handle their desired style of living or fund any possible emergencies. In that situation there is simply no financial reason to add to their net worth and thus exacerbate their potential estate tax liability. Of course, there are many issues here and many estate planning techniques that could be employed. The point is simply do not add to a situation that already poses problems.

PRINCIPLE SEVEN Seek Independent Advice When Any System Of Family Compensation Is No Longer Working

Many family businesses have compensation systems that simply evolved over time or were developed or imposed by previous generations of family members in control. Such systems may be the current cause of irritation, anger or even open hostility. It is very difficult for the family members embroiled in a difficult situation to, by themselves, develop a solution. In most situations if is better to select a person they all trust of develop a process they all agree to for the selection of a competent professional to help. It will often not be possible to invoke one or more of the above principles as, for instance, the “mark to market principle” may just be too dramatic an adjustment to some family members. A qualified professional with experience in family compensation matters will be able to suggest a solution or a process for a solution.

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