Are You Running a Business or a Charity? Truths About Paying Yourself

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ℹ ABOUT THIS EPISODE

Are you running a charity for your subs and suppliers? If your construction company can't afford to pay you a fair wage, something's seriously wrong. 

Wade and Stephen break down the critical balance between underpaying yourself (martyr syndrome) and overpaying (cash flow killer). Learn about S-Corp reasonable compensation rules, the 20% qualified business income deduction, and how to structure your pay for maximum tax benefits while building long-term wealth.

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⌚️ Key moments in this episode:

• 00:41 Exploring the Concept of Profit First
• 03:21 Understanding Business Structures and Compensation
• 07:54 Tax Implications and Reasonable Compensation
• 11:47 Balancing Personal and Business Financial Goals

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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com

Transcript

Wade Carpenter: [00:00:00] If your company can't afford to pay you, it can't afford you, period. A healthy business pays all its employees, including the owner. Otherwise, you're not running a company, you're running a charity for your subs and suppliers.

Welcome to the Contractor Success Forum. I'm Wade Carpenter with Carpenter Company CPAs, alongside Stephen Brown with McDaniel Whitley Bonding and Insurance. And today we're diving into a deceptively simple question, but one that should be considered very carefully. So Stephen, I bet you thought this was gonna be a pretty cut and dry topic. What do you think? 

Stephen Brown: Well, I did at first, but you know, more I thought about it and the more we talked about it, you're right. Are you running a charity for your subs and suppliers, and your employees? This is so important. I think this is one of the reasons you wrote the book, Profit First.

But the key point is, as an owner of a construction company, you have got to take out an adequate salary for yourself, not to just meet needs of your family. But also to plan where you're also meeting the needs of your company as well, and not [00:01:00] getting the two out of whack. 

Wade Carpenter: Right. 

Stephen Brown: You can say, hey, I wanna live totally through my company, and expense everything through my company. And then what does that do? So there's just a lot to this, Wade. 

Wade Carpenter: Yeah, I was actually asked this question. It's one that I've answered many times from different angles, and that's where I wanted to talk through some of the angles today and the thinking. You already brought up the Profit First, and if you can't afford to pay yourself, are you really a healthy company? If you got hit by the bus next week, could somebody step in and do what you do to run this company? Would they do it for what you pay yourself? But then again, like I said, too few owners really pay themselves properly. Or some of them go the other extreme where they take way too much outta the company. There's several things to unpack here, and that's where I wanted to sort of go with today's episode.

Stephen Brown: Yeah. And what kind of sacrifices do you think you have to make to your company that's more important to yourself and your family as well?

Wade Carpenter: Yeah. There's the mentality, which I took for many years in my own business. It's like, okay, my employee's gotta eat. I'm [00:02:00] just reinvesting everything back in there, and someday this is all gonna pay off. I hear that from contractors all the time because they don't have the cash flow.

If you're not able to take a salary, then something's wrong in your business. You need to build it so that you can do that. And Profit First is just one angle of that. But we also have other things like the S-Corporation rules and what is reasonable compensation. So I was just wanting to unpack some of that today.

Stephen Brown: Okay, let's go ahead because this is not just contractors that have this problem. A lot of business owners do. 

Wade Carpenter: Yeah, they do. I think back almost 20 years ago, I had an employee that wasn't with me long, but it was middle of tax season and I think at that time it was just me and her. I was paying her and running all over the place you know, not really taking, and, she said something to the effect that you're the martyr or something like that.

And I was like yeah, you're not doing this for your health, you're getting paid for it. That sort of hit me the wrong way. But too [00:03:00] often, we are the martyrs in our business. We take nothing and we just say, okay we're doing this for everybody else's benefit. 

Stephen Brown: And you may be right in the middle of that martyrdom, or you may have not even started your company yet, but either way, you're in a place where you really need to give this some thought and kind of turn things around, don't you? 

Wade Carpenter: Yeah. So I wanted to sort of attack that from a few different angles. First of all, the entity rules. One thing that a lot of people don't understand is if you're a sole proprietorship or a partnership and paying yourself on a W2, that's one misconception, is like you're not legally allowed to take a W2 salary from sole proprietorship or partnership.

You can take the draws, you're also gonna be hit with the self-employment tax. And that's where we get into all this stuff about S corporations and avoiding self-employment tax. Where people go the complete opposite way, we're gonna take everything in draws and avoid all the payroll tax.

But then you get into what's called a reasonable compensation issue with the IRS. [00:04:00] There's several angles we need to attack here, not the least of which the S corporation reasonable compensation issue. Do you ever come across that or have people talk about that?

Stephen Brown: I come across it a lot as you get close to the year end, especially with subchapter s corporations.

Wade Carpenter: Yeah. And a lot of times that's more of a question about tax. I mean, if you are an S corporation and you're not paying yourself on W2, yeah, you're avoiding some self-employment taxes. But you also run the risk of getting this reasonable compensation issue brought up from the IRS. The IRS seems to go in cycles where this becomes an issue in one part of the country versus another.

But, if you make a hundred thousand dollars plus, and you take it all in draws versus you know, taking zero in salary, you may be asking for IRS to come in and, if they claim that you're avoiding it, they can tax you for all of it, both the employer and the employee side. So that's one of the ways we think about it.

If you wanna stick with that for a little bit, the [00:05:00] reasonable compensation issue from the S Corporation, we want to defend against that. So we advise our clients to at least start taking a salary when they need to. How much is reasonable? We've got a service that we actually work with and we can go in and work with our contractor and say, okay, what do you do in your business? And what would it take to replace you is essentially the question we're asking. And this is what the IRS would say. They're gonna claim that all of it probably should be compensation to you, if you get into a problem with this. But these reasonable compensation reports is what we look at. We go in and say, what do you do? What's your education level? What would it cost to pay somebody to do what you do in this particular location? Do you have a degree? What level of experience, all of these things play into how much you would have to pay somebody. 

Stephen Brown: You mean if you were to go to work for someone else? 

Wade Carpenter: Yeah, exactly. To do [00:06:00] what you're doing. In a big city, you probably make more money than, you know, in the, suburbs or the rural parts of the country where you couldn't necessarily do that. So a lot of times we're looking at what you do.

The other part of that is also okay, maybe you're really good at estimating but you also think, okay, I'm running the company part of the day. So what would your value be as the CEO versus a lot of the contractors out there, especially when you're starting up, you're bootstrapping, you're scrubbing the toilet yourself. So if you're spending an hour a week cleaning the office, we can take that into account, try to keep that amount as low as possible.

Stephen Brown: At at a thousand dollars an hour, I think for office cleaning. Yes.

Wade Carpenter: No well, I mean we, for that particular purpose, we're trying to keep it as reasonable as we can.

And also, this is actually a good case. We did one for S corporation purposes, but I had a a business owner [00:07:00] probably about 10 years ago that got a Department of Labor audit.

And they wanted to know if this guy was paying himself. The guy makes $2 million. He takes home that much every year, like that's profit. And so obviously he was set up for this. And luckily we had been doing these analysis and it wasn't for this particular purpose. What, but when they came in and said you're not paying yourself enough, then we were able to pull this out and this guy doesn't work in the business much at all. He may show up an hour or two a week, and so we were able to demonstrate it, they completely left it alone. He's a prime candidate for the IRS bringing this particular issue up. But in that particular case, it saved his butt on a Department of Labor audit.

Stephen Brown: So, we've talked about that. Is there any other tax Implications, IRS Implications How you pay yourself we need to review?

Wade Carpenter: Yeah, a lot of people have forgotten this, the Big Beautiful Bill Act that just [00:08:00] passed reinstated the, basically the Tax Cuts and Jobs Act had expired from 2017. And, with the big beautiful bill part, they made that 20% qualified business income deduction under Section 1 99 A, that became permanent. That's a huge tax benefit to business owners.

Say you're a S corporation and you take X amount in salary. You got X amount that you're gonna take in salary versus, that salary becomes a deduction off your company income. Versus, okay, so if you reduce your company income, you're gonna get less of this 20% off the top qualified business income deduction.

So there can be a game of playing, reduce the payroll tax as much as possible, versus getting this 20%, and it's actually a mathematical formula that you can figure out like what is the optimal place? And it's, again, it could be something the IRS would look [00:09:00] at. That's another angle for this whole thing of, what do I pay myself? And I hope I didn't geek out too much, get too deep in that one. There is a optimal salary to optimize how much benefit you're gonna get out of this qualified business income deduction.

Stephen Brown: That's a great point, Wade. I'm sure lot of our listeners didn't know that. It's so interesting because my first conception on this podcast was, okay, a month to live off of, to take care of my family. How much do I have to make gross in order to net that much out and then turn that back around, and how much profit do I have to generate over expenses for my business to be able to afford to pay myself that?

You're right. It's amazing how many contractors out there just don't see the need to pay themselves at all. I think what you were saying about that martyr syndrome, it's not necessarily a martyr, it's just like you gotta work hard to succeed. You gotta pay your dues. And yes, that's all true, but at the [00:10:00] same time, you've gotta remember why you're in business. Sometimes it's just emotional. You're in business because it's just something you feel called to do, and you gotta think of all these aspects, don't you?

Wade Carpenter: Yeah, and I think sometimes we get in a situation, we get started and as you were just saying, it was just work a little harder and we get to this next level and things are gonna get better. We see that all the time, and that's part of the teachings of Profit First and my book of the growth, and you never see the cash from it.

My hope in the teachings of some of that is that you realize that, hey, maybe I'm not bidding enough in these jobs. And I know I get pushback all the time. It's like, if I bid anymore, I'm not gonna get the job. But if you can't make a reasonable living, should you go by-- you know, I'm not telling you to, because there's a lot of money to be made in construction if you're doing it right. But you know, have your own reality check. Are you actually bidding properly to be able to generate a profit and not leave it to chance?

Stephen Brown: Yeah. At [00:11:00] some point you're an employee and you're happy doing your job, going home, right? With no responsibilities. At other times you're promoted within your organization where you have more responsibilities and you start to say, well, for the amount of work I'm doing and the headaches I have, I should either be making more, or I should go into business on my own. And you know, that's a great point, Wade. It's why you wrote Profit First. It's understanding that concept of how and why you make a decision to go into the construction business. 

Wade Carpenter: Well, it's easy to say, hey, working for somebody else, I can just go do this myself. I've been doing this for a long time and I understand what-- well, that's running the business is not the same thing as being able to know how to do the work.

But, just to spin this to a different angle. We also have, what are your personal life targets? Are you taking home enough owner pay to cover your living expenses? Are you behind on your taxes? Are you having to [00:12:00] constantly borrow from your spouse's paycheck? Are you meeting your goals?

When I say personal life target, do you wanna send your kids to college? Do you wanna have some retirement? I think we were talking about that before the show. Are you making enough to where you put some aside for yourself so that you're not 65 years old and can't hardly get out on the job site anymore, or 70 or whatever your age you get to, and you have nothing saved. And I see it all the time.

When I'm looking at this question, I'm attacking it from different angles. What do you need to pay your bills every month? And that's one starting point. And depending on how your structure is, sole proprietor or S corporation or whatever you're structured as, you don't necessarily have to take it all in salary, but what is it overall that you need to be taking home, one way or another, to meet your goals as well as not just surviving every month, but being able to put something aside for yourself, for your family, have some kind of college savings for your kids, that kind of stuff?

Stephen Brown: And also [00:13:00] it's personal savings for yourself, for emergencies. You mentioned retirement. I've never met a new contractor starting off a business has given their retirement any thought at all. Literally. I mean, it's just not on my radar.

And also, how does this affect your marriage and your ability to communicate the income that's needed by your family? And what give and take is involved with you paying yourself, that's hurting your family? So we talk about that and we also talk in your book, Profit First for Commercial Construction, how to turn that around. It's a methodology. I just love this topic, Wade, because it's not only the tax implications of paying yourself, how you pay yourself, but it's the mentality and methodology.

When did that comment about you being a martyr hit home, and you were gonna do something about it? 

Wade Carpenter: Embarrassingly enough, it wasn't until really I started picking up Profit First. That was years later, but it was just one of those things [00:14:00] that stuck with me.

And actually that sort of brings me to another point, is, where are you in your business? If you're in startup phase versus scaling up or mature, and that can play into it.

Because the IRS can, they don't really necessarily have to, I've seen it thrown in people's faces, but if you're in startup mode and you're trying to really get off the ground, that's one thing if to prove it to the IRS, you get into this area where you're scaling up. And are you taking too much of the cash out to be able to, is it hurting your banking or your bonding? If you take too much and you're hurting the working capital, there's gotta be some kind of happy medium.

I know you brought up the very case that I was gonna talk about. When you have a certain lifestyle, if you're used to making so much or bringing it home so much, you get dependent on that. And so it's hard to scale back.

As I said a thousand times on the show, money can come in and go out just very quickly in [00:15:00] construction, but it's easy to go ahead and take a big old draw and then, live life to the fullest. And then, once you got those toys and those kind of things, you can't really scale back. And so that's where we saw a lot of people after 2008, 2010, and some of those crashes. People had a hard awakening because they couldn't scale back.

Stephen Brown: How fast can you scale back? So that's making the tough decisions about letting employees go when you have to keep your business afloat. Also, communicating with your family, changing a, a lifestyle situation that needs to be corrected in some way. This is all a huge part of it. And I get the, the dream of capitalism should be, I make as much money as I can for myself, and that helps everybody. Maybe I'm being little, a little too hard on that definition of capitalism. But maybe I'm talking about the American dream. You work hard and you deserve what you get. And the more you get, it shows how much better of a [00:16:00] worker you are.

And we've always said in the Contractor Success Forum, it's better to work smarter than harder in construction or any industry, to not take on a standard of living that is gonna strain you in the future, or ever strain you. And that's a hard decision to make, because you wanna make your family happy and you also want to say, hey, I have killed myself for the last five years for this company. Now I'm gonna enjoy the benefits of it. 

Wade Carpenter: That's another great angle on this thing. I've got specific contractors that I can point to that I just want to shake them and just say, okay, you've got a great business here, but you keep dragging all the capital out. And it's just like a teenager.

I've heard that the newest generation is starting to save for retirement now, more so than a lot of like my generation, they're recognizing the value of we put a little bit in now. But I use this analogy to say, okay, if you put in a little bit now, by the time you retire, you could be a, a millionaire, a [00:17:00] multimillionaire, by just putting something aside. Can we put off some of that self gratification right now to make sure that we have a healthy company so that we can get to these levels?

What I'm trying to figure out is where can we get to this balanced

in between underpaying ourselves and overpaying? 

Stephen Brown: Right. So this is a great topic and a decision to make. Because there's a lot of people out there might say, well, look, I need to take the money while I'm young and do these things while I can and never know what the future will hold. And then we were talking about a newer generation putting aside for retirement.

And we've also talked in the past about how just savings is done forcefully through social security for your retirement and also for example, paying your property taxes when you have a mortgage. It's an automatic thing you don't think about. It forces those that don't think about it, it, to think about it, right?

 So what do you think the next step is here for someone who's listening to this podcast to analyze this [00:18:00] and pay themselves properly? 

Wade Carpenter: Well, again, you just sort of brought one of the Profit First things up. You put aside a little every paycheck. Make sure those property taxes are the, you know, the mortgage company escrows it for you. It's the same kind of deal. And yeah, there's a Profit First angle.

Where this sort of started, this is a question I've never really took this deep of a dive into, but the thought of what should I be paying myself? And when I get into it, okay, we are doing these reasonable compensation reports for people.

This is really where the genesis of this whole episode came from. What would it take to replace you? And so we started adapting these reasonable compensation reports to put it in a light for the Profit First community. What would it take for your expertise, for what you do in this particular area?

You know, that's some starting point. Because a lot of people don't know where to start. So I don't know what our listeners think of this episode, but if nothing else, I hope I made you [00:19:00] think about it.

Stephen Brown: I do too, because it's not just part of the equation. It's everything, I think. 

Wade Carpenter: Yeah. So if any of our listeners have any thoughts on, what we talked about today, what's reasonable? Do you take too much? Do you take too little? We'd love to see those kind of things in the comments below.

We do this every single week. We bring topics to contractors that you can't find anywhere else. So if you would we'd like to continue doing this. Please share, subscribe. It always helps us out, and we will see you on the next show.