Assembled Workforce or Developed Process Effect
By Jason Watson, CPA
Posted Thursday, October 7, 2021
As alluded to earlier, the business’s ability to earn revenue without the direct involvement of the owner(s) can be huge. Consider an actor or an on-air personality (WCG has a handful of these clients). Would revenue continue after the owner stopped working?
For example, you start off as a one-person engineering firm earning $150,000 net ordinary business income after expenses and deductions but before shareholder salary. You pay yourself $65,000 and pocket $85,000 as shareholder distributions. Done.
Time moves along, and you’ve hired eight other engineers and they are paid $90,000 each but contribute $60,000 to the bottom line of the business (using the $150,000 number above as a proxy). Even if you increase your salary to $150,000, you still have $480,000 ($60,000 x 8) available for shareholder distributions.
Yes, this is overly simplified but it illustrates a huge point. Should you sell your engineering business to an investor, he or she would hire another person for $150,000 to run the business and use the remaining $480,000 as a return on investment because of the assembled workforce effect. You are no different. As mentioned several times throughout our book, you are both employee and investor when you own and operate an S corporation.
Using the example above, the employee and investor are the same person when you own it, but we must always bifurcate these worlds because they are not directly related to each other in terms of the split. Granted, if you saw your boss (the investor) making $480,000 perhaps you would ask for more than $150,000 to run the business. Then again, if $150,000 is the going rate, that is what your boss will pay you regardless of what he or she makes as a return on investment.
Using our previous question about the actor or on-air personality, would your answer change if this person developed a process such as podcasts, videos, merchandising, likeness licensing, etc.? Of course it would. An actor who earns $300,000 from acting and $200,000 from other sustainable sources is much different than the surgeon who earned $500,000. As such, reasonable S corporation salaries would certainly vary.
Here’s another one to make you go hmmm. How about a financial advisor who has been in the business for 25 years? A lot of their present-day income is truly deferred earnings from multiple decades of hard work. Sounds more like an investment, doesn’t it? And as we’ve discussed, a return on an investment is more of a shareholder distribution argument than a reasonable salary argument.
We could go on and on with this.
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