Stop kidding yourself about kidsÕ pay

Arguments many business owners use to justify paying their children inflated salaries just donÕt hold water.

For 13 years, the oldest son in a family business didnÕt complain about receiving the same pay as his four brothers. Though Jeff worked three times harder than the othersÑwith responsibility for strategic planning, cash flow, and relations with suppliers, lenders, and big customersÑhe knew that his mother wanted all her sons to benefit equally from the business. After all, she had promised that each would have a position in the company as a legacy from their father, who died unexpectedly at age 49.

Finally, though, Jeff decided that heÕd had enough. He told his mother, the sole owner, that he would start a competing firm unless she sold the business to him. She agreed to the sale. Jeff became the new owner and set about cleaning house. He fired all four of his brothers, who ranged in age from 24 to 36 and made $50,000 each a year. His reason: They answered to no one on the job, felt no responsibility for the businessÕs success, and considered their well-paying positions a birthright.

An extreme situation? Perhaps, but this familyÕs story points to the emotional sparks that underlie the compensation issue. Like JeffÕs mother, many business owners view the company as the glue that will hold the family together. They put personal values, such as family unity and a desire to treat all children equally, above the business values of allocating resources to that which adds the most value, and compensating employees fairly. At some point, the salaries paid to family members can become a true breach of business values. ThatÕs when the sparks start to fly.

The trick is to maintain your business values while giving your children a chance to participate in the companyÕs success. To create that balance, you need to set some rules for hiring and compensating family membersÑand follow them no matter what. 

Salary levels for family members should be based on their education, experience, responsibilities, and maturity. In short, the pay should be competitiveÑno more or no lessÑbased on the amount that would be paid to nonfamily members hired for the same position and at the prevailing rates in your industry and region.

The problem is that many family business owners are tempted to pay their children more than these rules would allow. (Of course, some owners take the opposite tack and underpay, but thatÕs another story.) Some overpayers justify inflated salaries for family members with a subjective, ÒTheyÕre my children.Ó Others offer more objective reasons tied to their childrenÕs financial needs and the companyÕs tax planning goals. But neither line of reasoning holds up under careful scrutiny. Here are four arguments a parent might give for inflating a childÕs salaryÑand why they donÕt hold water:

Argument 1: ÒHe or she deserves more than the market rate since his commitment to the business is greater than the average personÕs.Ó

The bottom line is that your childÕs market-rate salary should reflect the benefit the business receives from his or her work. A greater level of commitment is insignificant unless it results in a current or future benefit to the business thatÕs not accounted for in the base salary. If that is the case, and your child has surpassed expectations for the year, you could supplement his or her salary with a performance-based reward.

If your son recruits a new customer who increases the companyÕs sales by 10 percent, you might pay him a year-end bonus of 10 percent of his salary. Or, if you believe your childÕs commitment to the company will increase its future market value, you could reward him or her with stock options. One example: Your daughter initiates a contract with a new supplier that should double sales in five years. You could grant her stock options to be exercised during the five-year period at todayÕs market price. These two options acknowledge the childÕs commitment but reward him or her only if that commitment profits the business.

Argument 2: ÒA market-rate salary really isnÕt enough for my childÕs financial needs. Why not pay more, since itÕs deductible?Ó

ThereÕs one potential scenario that may legitimize this argument. If your children own life-insurance policies on you and your spouse to create the liquidity needed for estate taxes, you may want to supplement their annual salaries by the amount of the premiums. That way, they wonÕt get stuck paying the bill themselves.

For every other case, earning a market-rate salary is not the end of the world; it may simply mean the end of a certain lifestyle. In fact, inflating your childrenÕs pay to satisfy lifestyle needs will foster a birthright mentality, which hinders the development of strong and independent leaders who can carry the business into the next generation. Paying them the going rate will boost their self-esteem, maturity, and long-term career development, as they make more money by working hard and advancing.

This practice may save some headaches with the government as well. While many business owners believe an above-market salary is always deductible, thatÕs not necessarily so. The IRS has been known to deny deductions for Òunreasonable compensation,Ó or the difference between the going rate for a job and the total compensation paid. In fact, the IRS might treat this excess compensation as if you, the shareholding parent, had received it as a dividend and given it to your child as a gift. That means the amount of above-market salary is taxable to you as stock dividends.

Argument 3: ÒWeÕve paid her $50,000 for three years, so it would lower her standard of living to reduce the salary now.Ó

Although your child may not have been deserving of her excessive salary all along, itÕs true sheÕs no more deserving of a sudden cut in income. Fortunately, there is a partial solution to this awkward situation. Lower her salary to the market rate and offer to supplement it with up to $20,000 annually in tax-free gifts from you and your spouse.

The downside to this approach is that gifts from Mom and Dad can make it tougher for young adults to establish independence. After all, they can rationalize that a salary is earned. A gift is not. But at least your child will understand the market value of the job and will no longer hold the misperception that sheÕs worth $50,000 to the business. In the best scenario, switching to a gift will make your daughter uncomfortable, and sheÕll decide to make do with the salary she should have been earning all along.

Argument 4: ÒBy paying bigger salaries to my kids, I can transfer wealth free of estate taxes. Ó

While itÕs true that paying high salaries takes cash out of the business and reduces profits, it wonÕt lower your companyÕs value for estate tax purposes. Indeed, a valuation expert or the IRS will add back any excess salary paid over the years to the businessÕs value. In the meantime, this tactic can be unnecessarily expensive because your children will have to pay income taxes on the inflated salaries.

More important, the true basis of wealth transfer in a family business lies with the ownership. To lower your estate value, you and your spouse can give each child stock in the companyÑup to $20,000 worth a year free of gift and estate taxes. If you have several children in the business and one is emerging as the leader, he or she can receive a larger block of stock. You and your spouseÕs combined lifetime unified credit allows you to transfer $1.2 million in tax-free gifts. While many parents feel that paying the going rate furthers business values to the exclusion of family values, itÕs just not so. By compensating your children as you do other employees, youÕll ultimately be doing whatÕs best for themÑand for your business.