Family payrolls range from sensible to downright whacky. Here’s my take on compensation in business families.

“Sweat equity” entitles a relative to be paid for the useful work he or she contributes to the family enterprise. “Blood equity” entitles family members to distributions and benefits from the company solely because they are relatives.

One earns sweat equity. One is born to blood equity. The root cause of most conflict about family compensation is failure to honor the difference. Most compensation conflict involves unhealthy mixtures of the two.

A useful measure of sweat equity is the amount of compensation the company would have to pay a non-relative to do the same job as a family employee. By this measure, some family members are underworked and overpaid, while others are overworked and underpaid.

To the extent a family employee is overpaid, his excess compensation reduces other relatives’ blood equity. To the extent a family employee is underpaid, the cost savings increases other relatives’ blood equity at his expense. The underpaid family employee is often comforted by vague assurances that, “Some day this will all be yours”, implying that future ownership will eventually square things for low pay today. Equal pay for all family employees almost always generates sweat equity-blood equity imbalances: equal pay is seldom fair, and fair compensation is seldom equal.

Compensation for work done has three major components, each to reward different incentives: basic salary or wages is payment for trying; a bonus is for excelling; and retirement benefits reward longevity and loyalty. These incentives can become lost in the family’s eagerness to distribute company profits at minimum tax cost, and by family reluctance to pay relatives according to merit.

Whether they try hard or not, salaries and wages of family employees are usually generous. If unduly generous, overpayment can tie a family member to the company with golden handcuffs — he or she couldn’t earn that much in the competitive job market.

Deserving unrelated employees may get bonuses, but the lion’s share of the bonus pool usually goes to family employees, not for excelling, but more or less according to their share ownership. Blood equity trumps sweat equity.

Unless they’re pretty outrageous, family salaries and bonuses are usually tax deductible to the family company. The outrageous portion could be taxed as a dividend, but dividend taxes are low now, thanks to recent tax cuts.

Longtime unrelated employees may get retirement benefits, but family employees customarily get all the law allows, a vehicle to defer further distributions to family from company profits in tax efficient ways. Family loyalty and longevity aren’t very relevant.

A heads up: Lots of family payrolls reflect outdated tax laws, or haven’t been reviewed or updated, except for cost of living increases, since the most recent family employee was hired.

The best compensation structure is one that works for the family and the business. What works for one family would court disaster in another. Equal compensation for all avoids the delicate sweat equity question: “What are you worth to the family company?” Sometimes, however, worth to the company gets garbled with worth to the family, and that perception causes trouble. Be very careful and clear about your relatives’ perceived worthiness.

Ordinarily, I favor a family compensation structure that recognizes and rewards differing sweat equity. But transitioning from an out of whack family payroll to a more sensible one, e.g. from equality to merit, can be an exceedingly delicate mid-course correction. Happy landings.

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