Direct Form of Compensation – Four Different Types
There are four different types of direct compensation for employees. These include: 1) Hourly Compensation, 2) Salaries, 3) Commissions and 4) Bonuses. There is some misinformation related to direct compensation as this subject relates to owners of a small business. Items such as distributions or dividends or some assigned values on the K-1 are generally not compensation but more akin to a return on investment. This article will cover these four different types of direct compensation. In addition I will describe some of the issues and misunderstandings in regards to business owners and their respective assigned profits from the company.
This article is an in-depth explanation of these direct types of compensation. If you desire a summation of the subject matter please read the ‘Learning Objectives and Highlights’ section below. For a more in-depth understanding continue to read the balance of this article.
Learning Objectives and Highlights
This article identifies the four different types of direct compensation. The following are the four and their respective attributes in summary format:
- Hourly (Wages)
- Traditionally used with unskilled and semi-skilled labor
- No expectation of ongoing employment
- Non-Exempt for overtime wages
- More frequent pay periods
- Salary (Wages)
- Designed for more well educated positions
- Employees are customarily involved in management
- Expectation of loyalty from employee to the company
- Expectation of priority for retention and ongoing work
- Many salary based employees are Exempt from overtime compensation
- Less frequent payroll runs
- Oriented towards production
- Workloads are inconsistent
- No overtime
- No expectation of ongoing employment
- No loyalty from either party or duty to perform
- Very common in certain industries
- Goal driven
- No expectation from employees
In addition to the above, the owner of a business often receives a profit and other forms of income from the business. These other forms of income are a result of his ownership position, NOT compensation but a return on the investment. These other sources include profit, interest, capital gains and losses, recapture and distributions (sometimes referred to as dividends).
If you desire to learn the details and their corresponding issues, please continue to read.
I’ve highlighted the two forms of compensation in The Different Forms of Compensation which is an introduction article for this subject. I encourage you to read it first. In addition I have four other articles that I will reference in this in-depth explanation and if you desire an expanded scope of knowledge of this subject matter, please read the following:
- At-Will Employment Doctrine – explains the current legal understanding between the employer and employee as it relates to the ongoing working relationship. It identifies three legal exclusions and which states acknowledge these respective exclusions.
- Exempt and Non-Exempt Employees – identifies which employees are exempt from overtime wages and explains the Federal Labor Standards Act in regards to this issue.
- Gain an Understanding of the Work Environment – an essential first step to developing the policies and procedures manual, the owner needs to document the work environment and the different characteristics needed in the personnel to perform the respective duties.
- What is a K-1? – explains the various forms of pass-through entities for income tax purposes. This article helps the reader to understand the relationship of taxable income and compensation in reference to the owners of a small business.
There is one other issue in relation to the tax implications of each type of direct compensation. This article uses the terminology and tax regulations related to the U.S. Internal Revenue Code. In each section below, I separate out the tax aspects separately so for those of you from different countries; feel free to skip that particular subsection.
Hourly pay is the most often used direct form of compensation. It is designed for employees with unskilled or semi-skilled backgrounds. It is important to understand that hourly wages are not customarily used with college educated or licensed individuals. Sometimes the term ‘Wages’ is used in lieu of hourly pay. Wages is really more of a generic term covering all of the direct types of compensation. It is more commonly used with hourly pay than any other type of direct compensation.
Traditionally, those employees that work part-time are only paid hourly wages (some companies will use commissions). There is an implied relationship between the hourly paid employee and the employer of no guarantee of ongoing work. See At-Will Employment Doctrine. This is an important attribute of this type of direct compensation. Often employees misunderstand and believe they are entitled or guaranteed so many hours per week. To prevent this misunderstanding, the employer should include in the employee handbook a clear definition of the term hourly wage.
In addition to the above, almost every single hourly paid employee is a Non-Exempt Employee under the Federal Labor Standards Act. It is almost impossible for an hourly worker to be Exempt, there are exceptions, but it is rare. Therefore, if the employee works over 40 physical hours in any seven day period, you must pay that employee at least one and half times their normal hourly pay. There are no exclusions and sometimes employers believe certain employees are excluded such as deputies or first responders (EMT’s, Park Rangers etc.). These types of hourly paid employees are still Non-Exempt under the law.
I’m often asked the question about certain ‘Skilled’ labor as to whether they should be hourly or salary paid. These skilled laborers include:
- Construction Laborers
The answer depends if they are involved in any management decision process. Usually those with maturity and longevity with the company convert to a salary as a reward for a managerial role.
One final note related to hourly compensation. It is more common to pay them weekly than in any other pay cycle. This is more customary and it relates to the nature of the relationship between the employer and employee. In addition, certain industries pay on a weekly cycle including construction, grocery stores, food service and retail.
Internal Revenue Service Code
The IRS Code uses the term ‘Wages’ as it refers to hourly compensation. You rarely find the term ‘Hourly Compensation’ in the Code and thus the reason for the common substitution of wages for hourly pay. Wages are a subgroup of ‘Earned Income’ which refers to the physical presence and work required to earn the pay. For most hourly paid taxpayers it is reported on Line 7 of Form 1040. The most common reporting exchange between the employer, employee and the IRS is Form W-2.
Salaries are customarily paid to more educated employees. In addition it is a tool used to retain employees by providing a consistent periodic payment without interruption to an employee. The relationship between employer and employee is more in tune with recognition of responsibilities for the employee and loyalty for the employer. This creates a form of a mutual covenant that benefits both parties.
Salaries are customarily an annualized number and the frequency of payment is an industry related function. The following is a short list of various industries and their respective frequency of payment related to salaries:
Industry Frequency of Payroll for Salaries
Large Corporations Semi-Monthly
Small Business Bi-Weekly
Health Care Bi-Weekly
Please note that the frequency of salary pay periods is rarely weekly whereas with hourly wages, the pay cycle is more often weekly.
Many salaried personnel play pivotal roles in the management of the company. As such, they are often exempt from overtime compensation. Furthermore, salaries are often used to pay professionals. The Fair Labor Standards Act carves out professionals as exempt from overtime pay. This tends to force salaried personnel to work more hours on a weekly basis in order to continue as a salaried individual. For the employee, that regular consistent compensation is essential for their personal long term goals.
Internal Revenue Service Code
Just as with hourly paid employees, salaries are referred to as wages in the eyes of the IRS. Therefore, this income is also reported via Form W-2 to both the employee and the Internal Revenue Service. Individuals report this income on Line 7 of their Form 1040. In addition, salaries are taxed for Social Security purposes and Medicare and are classed as ‘Earned Income’.
Commission Based Compensation
Commissions based compensation is utilized by companies to incentivize employees to produce at higher than normal levels than hourly or salaried employees. Some industries use this form of compensation because the employer cannot guarantee sufficient work or there is an extreme risk related to the price for the goods or the ability to generate the goods themselves.
The best example is the fishing industry. Captains of boats pay a commission to the deckhands based on their position. There is no guarantee of catching fish nor a guarantee the market price for the fish will be sufficient to warrant the risk.
Other industries that pay on a commission basis include:
- Insurance Sales
- Auto Sales
- Real Estate Sales
- Delivery and Route Drives (Baking Goods, Soft Drinks, FedEx)
- Financial Brokerages (Specifically the Agents)
- Agricultural Pickers
- Hair Stylists
In general, most commission based employees are exempt from the overtime pay formulas contingent on their average compensation exceeds one and half times what a comparable hourly worker is paid. The only drawback to this formula resides in Tipped Income. Waiters and waitresses are considered non-exempt employees and must be paid time and half for overtime. This is why in the restaurant industry you rarely find employees that work beyond the 40 hour work week.
The primary value to an employer is the risk shifting of production and corresponding earnings to the employee. This works well in most sales based industries and thus the more common form of compensation is commissions in retail when large ticket items are sold.
Some companies use a combination of a salary with a commission. This is more common with higher levels of knowledge required of the employee such as pharmaceutical sales or marketing and advertising sales. Some industries are seasonal, to retain the employee during the slower periods, a base salary is provided and commissions act more as a bonus than as the actual primary source of income.
Internal Revenue Service Code
For the employer, the company must treat the commissions earned as wages and withhold the appropriate amount of taxes and match the Social Security and Medicare. As with hourly and salary, a W-2 is used to report the earnings. It is rare to treat the employee as an independent contractor. The employer should get permission from the IRS to assert a subcontractor relationship.
Bonuses are the least used type of direct compensation. It makes sense. Bonuses are designed to incentivize employees to work additional hours to achieve certain milestones in production etc. However, this is not always the case. The most common bonus given by companies is the annual Christmas bonuses. The Christmas bonus is traditionally a way to thank the employees for a financially successful year. But many companies issue this bonus because the owners feel compelled to assist their employees in providing for their families during this period.
I encourage you not to fall into this trap because employees will feel entitled to this annual supplement and will in turn adjust their lifestyle throughout the balance of the year expecting a Christmas bonus. For those of you that are Chevy Chase fans, his Christmas Vacation movie was based on the fact that he EXPECTED a bonus to buy a pool. In the movie the company owner had issued bonuses for nine years in a row and only sent Christmas cards in this particular year. Thus the dilemma; it still is one hilarious movie though!
Bonuses provide a lot of latitude for business management to reward employees for unique performance. I’m not as inclined to advocate for them because I believe employees should be satisfied with the agreed compensation as negotiated at hiring for 100% effort. But many owners of small business feel compelled to issue bonuses to employees especially during the holidays.
Bonuses paid to employees should correlate to the particular goals at hand. I’m often asked ‘What is an appropriate bonus to pay an employee for a particular project?’ I always defer to the age old royalties formula which is no more than 15%. If employee earned $3,000 in gross wages during the project period, the maximum bonus should not exceed $450. Remember, it is a range up to 15%, not a requirement.
Internal Revenue Service Code
Similar to hourly, salary and commission based compensation; bonuses are treated as earned income and therefore are taxed just like all other wages. Form W-2 is the reporting format for the employer, employee and the IRS.
Issues and Misunderstandings
One of the more common misunderstandings with compensation relates to other forms of wealth transfer from the company to the owners. Often the owners are employees too. In addition to their salaries, owners receive or earn profits from the company. These profits are paid out in the form of dividends or distributions. Dividends and distributions are not earned income and therefore not a direct form of compensation. They do not even qualify for inclusion in one of the indirect forms of compensation. They are exactly what they are categorized as, profits.
These profits are included in other lines on Form 1040 and therefore not a type of direct compensation. This information is reported to the IRS via 1099-D’s or the more common K-1 report.
Naturally the profitability of the company is inversely related to the direct compensation paid to the owner. As direct compensation increases, the bottom line will decrease and vice versa. When the owner or owners combine their compensation and profits together, they can determine total value the company brings to the owner.
One of the more interesting issues is when owners of businesses compare their profits with each other. I always laugh because one guy will state he earned a greater profit than the other yet the second business owner paid himself three times more money in salary and easily accrued more value from his business than the first owner. Be careful when you compare the profitability of small businesses against each other. The first key to a fair comparison is to determine the direct compensation and then add the profit to determine the overall value the business brings to the owner. Compare the combined amounts. Act on Knowledge.
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