Blog: How to calculate your compensation as a practice owner
Michael A. Kling, OD
The views expressed here belong to the author. They do not necessarily represent the views of Optometry Times or Multimedia Healthcare.
As a business coach, I frequently analyze optometry practices to help answer common question: Where is all the money?
I often find that practice owners are taking too much or too little out of their practices in owner’s pay. When the owner is taking too little out, it is because there is not enough cash available to pay a reasonable wage. If the OD is taking out too much, he ends up starving the business of much-needed capital.
Another common practice is an OD using the business bank account as a personal ATM, withdrawing funds when cash is available, to meet his personal lifestyle needs.
Sometimes referred to as “bank balance accounting”- making financial decisions based on the bank account balance for business or personal reasons-this can lead to serious financial consequences such as poor cash flow, inaccurate financial statements, and a potential International Revenue System (IRS) audit-not to mention more than a few sleepless nights.
But knowing how much you should be paying yourself isn’t always quite clear.
Related: How to calculate the value of your practice
Compensation considerations
Assuming you own the business, there are two considerations when determining your own pay.
First: How much can I pay myself?
Just like any other expense in your business, your personal compensation needs to fit within the framework of the economics of your practice. Overpaying yourself creates the same cash flow problems as overspending on frames, rent, or staff.
Second: How much should I pay myself?
If your business is an S-corporation, for instance-regardless of what you think you are worth-the IRS has its own opinion of how much you should be paid as an investor-employee of your own company.
How much can I pay myself?
It may be tempting to withdraw money from your business account whenever you need it, especially when it is available. However, without a clear understanding of how much your business can afford, you are almost guaranteed to find yourself in a cash-flow crisis before long.
Determining how much your practice can afford to pay you depends largely on three key factors:
1. Size of practice
2. Control of expenses
3. Amount of debt
The size of your practice usually controls how much you can afford to pay yourself both as an employee and investor in your business.
Equally important is how well you manage your expenses-in particular, your cost of goods sold (COGS) and people costs because these often make up as much as half or more of your company’s expenses.
It is possible that a well-run $800,000 practice could outperform a $1,000,000 practice if its expenses are managed properly, resulting in more resources available to pay the owner.
Finally, the amount of debt you have makes a significant impact on what is left over to pay yourself. In fact, this is probably the biggest threat I see to an owner’s pay.
It is easy to fall into the trap of investing in the latest technology, then accumulating massive amounts of practice debt. Because this debt has to be repaid out of the business’s profits, burying your practice in debt can take a major bite out of your personal income.
Related: How to overcome barriers when buying or selling a practice
To help understand what your business can afford to pay you, it’s important to get to know your cash flow. A good place to start is by looking at a one-year snapshot of the practice’s profit and loss (P&L) statement.
The net operating income (NOI) will show what is left over after expenses are paid but before the ODs-both owners and associates-and debt is repaid.
Once you have determined your NOI, subtract debt payments (principal and interest), tax reserves, and capital reserves (such as emergency funds) planned to cover cash shortfalls on slow months or for unforeseen disasters.
In theory, what is left over would be available to compensate the practice owner.
An example of how an average size practice might determine how much it can afford to pay its owner is shown in the table below.
If after performing this exercise you do not like your available compensation, and think you deserve more, there are three choices:
1. Increase practice revenue
2. Decrease expenses
3. Eliminate debt
Because this money belongs to Uncle Sam-not you-your tax reserves should never be neglected Avoid prioritizing or padding your own compensation before considering your capital reserve targets.
This is your safety net when there is a slow month, an office flood, personal illness, or a planned vacation. Only after these obligations have been met should you consider what is left to pay yourself.
Check out last week's blog: How presbyopic patients can determine their dominant eye
How much should I pay myself?
Once you determine how much your business can pay you, the next question is how much should you be paid, and how?
Some practices elect S-corporation status-which passes the P&L of the company through to the owner-to avoid self-employment tax. These include Social Security (old-age, survivors, disability insurance) and Medicare (hospital insurance) taxes that employers are required to pay for and on behalf of their employees.
The Social Security tax rate is currently 12.4 percent on the first $132,900 earned, and the Medicare rate is 2.9 percent with no cap on income. These taxes are split equally between the company and employee, which means the company is responsible for 7.65 percent of Social Security and 1.45 percent for Medicare.1
Federal taxes
• Social Security: 50/50 split between employer and employee up to first $132,900 earned
• Medicare: 50/50 split between employer and employee, no cap on income
• Federal Unemployment (FUTA): Up to first $7,000 earned
However, if you own your company and are both the employer and employee, you would be responsible for the entire tax (15.3 percent). That means for every $100,000 of W2 income earned, your self-employment tax would be $15,300.
By taking that same $100,00 as a distribution instead of a W2 wage, you would avoid the tax liability altogether and save yourself $15,300 in taxes.
Because of this advantage, it can be tempting for S-corporation owners to take their compensation in the form of a company distribution rather than a W2 salary.
This is a major red flag with the IRS. If it is determined the owners are not taking their compensation appropriately in the form of W2 income to avoid self-employment taxes, an audit could loom.
Related: 5 tips to prepare for practice purchase
Determining “reasonable compensation”
According to the IRS, S-corporation owners must pay themselves a “reasonable compensation” if they are providing “meaningful service” to the business.2
If an OD is actively seeing patients and managing the business, the IRS’s expectation is that the OD would be compensating herself appropriately as a W2 employee.
IRS rules state that employee-owners must pay themselves a comparable wage to that of someone with similar training and experience performing the same job.2
For example, if an OD is seeing patients three days per week, spending one day performing administrative duties, spending a half day as the practice CEO, and taking a half day off for personal time, reasonable compensation could be calculated based on what it would cost to have an associate doctor in the practice three days per week, an office administrator one day per week, and a CEO one half day per week.
Example of fair market compensation
• Clinical OD: based on $130,000 annual compensation
• Practice CEO: based on $80,000 annual compensation
• Practice admin: based on $40,000 annual compensation
Once you have satisfied the IRS requirements for reasonable compensation by paying yourself a fair market W2 wage, it would seem reasonable to take additional profits as a distribution, which would avoid additional payroll taxes.
It is also important to consult a certified personal accountant (CPA) or tax advisor, since there may be other considerations may affect this decision.
Wrapping up
Determining a reasonable compensation for you as the practice owner is a critical part of operating a healthy practice. While overpaying yourself might make you feel more successful, your practice is likely being drained of necessary fuel it needs (cash!) to operate successfully and withstand the inevitable ups and downs.
On the other hand, not paying yourself a reasonable W-2 wage and using a business bank account as an ATM, could expose you to unwanted IRS interest in your practice.
The best advice is to consult with your tax specialist to offer guidance and determine a number to keep the practice healthy and viable and out of trouble with the IRS.
References:
1. Internal Revenue Service. Understanding employment taxes. Department of the Treasury. Available at: https://www.irs.gov/businesses/small-businesses-self-employed/understanding-employment-taxes. Accessed 3/13/19.
2. Internal Revenue Service. Publication 535: Business expenses. Department of the Treasury. Available at: https://www.irs.gov/pub/irs-pdf/p535.pdf. Accessed 3/13/19.
