By Danny Klinefelter

DTN Farm Business Adviser

A major source of friction in some of the family farm businesses I deal with focuses on compensation. There are a number of complex and often conflicting issues involved, ranging from tax considerations to parental concerns. The issue is further compounded when there are both family and non-family members in management and/or when some family members work in the business and some are employed outside of the business.

Craig Aronoff and John Ward, two nationally recognized experts on family owned business management, offer the following simple but very important advice to family business owners when establishing compensation policies: "Pay family members what the job is worth. If you want to otherwise enhance their standard of living or reduce your estate taxes, do it through gifting--preferably through private gifts outside the business."

Their point is that pay involves not only money, it also conveys a message. In order to keep the message clear, I suggest thinking of family remuneration in five parts:

1. A salary or wage for the job based on its market value, i.e., not paying everyone the same.

2. Performance bonuses for meeting certain predetermined objectives.

3. Profit distributions based on company profitability.

4. Capital distributions (dividends) based on percent ownership.

5. Parental gifts for estate planning and expressions of love for family members.

In special circumstances, such as a home purchase or major medical problem, owners may want to take draws against their capital account. However, unless the draw is handled separately as an interest-bearing loan, their ownership percentage would be proportionately reduced. I believe the interest-bearing loan collateralized by ownership interest is viewed as fairer and more transparent, even if the loan has an undefined principal retirement timetable.

Parents invite trouble whenever their motives are unclear. Some parents underpay children in order to convey a parental lesson or to control their lifestyle. Others overpay them in order to buy their dependency, to provide for their grandchildren or to allow a spouse to stay at home. By not recognizing or admitting their intent, parents can create an ambiguous pay rationale. Furthermore, as compensation levels become less justifiable and more arbitrary, pressures increase to keep information secret from other family members and employees. The results will almost always be detrimental to the business in the long run because values and trust are compromised.

There are three fundamental principles to keep in mind when considering compensation for family members.

1. Separate reasoning and actions into three categories: What is appropriate as an employee, as an owner, as a family member.

2. Make sure communications and expectations are unequivocally clear.

3. Minimize the resentment than can occur between family members (owners) who work inside and outside the business. If your farm is a stock that never pays investors a dividend -- even after the best year in the last 100 -- those without an emotional attachment will question their long-term ownership. Gerald Le Van, a family business adviser, often referred to this as the "parasites and plunderers" issue.

Le Van is a little over the top, but what he means is that operators inside the business view investors/outsiders as parasites draining capital that could be used to grow the value of the company. Outsiders see the day-to-day managers as plunderers using equity to reward themselves and their personal lifetstyle, without necessarily building company value.

What I notice is too many farm families overuse the concept of sweat equity and defer rewards until a senior partner's death or retirement.

Unless handled properly within an estate plan, the underpaid manager is likely to receive exactly the same compensation as those who didn't contribute to building the farm's value. Sweat equity only makes sense if you defer your own wealth, not enhance something all the other heirs will share.

Editor's Note: Danny Klinefelter is a professor and Extension economist with Texas AgriLIFE Extension and Texas A&M University and a founding member of the Farm Financial Standards Council. He also directs The Executive Program for Agricultural Producers (TEPAP), a management short-course for farm producers held each January, and its alumni association, AAPEX. For information on TEPAP go to http://tepap.tamu.edu/…

(SK)

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