How Should You be Paying Yourself as a Business Owner
to Reduce Your and Your Business’s Overall Tax Obligations?
Our Guide Breaks Down the Details
Probably the most frequent question that small business owners ask their lawyers and accountants is “how should I be paying myself as a business owner” in a way that will allow you to take advantage of tax minimization strategies, while still staying completely legal and in compliance with all laws and regulations established by taxing authorities.
Most small business owners tend to not be particularly interested in pushing the envelope too far when it comes to skirting tax obligations. That being said, they do generally want to know what options exist for “legally” taking advantage of the same provisions that large corporations use (affectionately called “tax loopholes”) that will minimize their overall tax obligation, and more importantly, legally reduce the total amount of taxes they must pay for their own compensation.
So, if you are a small business owner who feels like you’re giving up close to half (50%) or more of your earnings in taxes at the end of the day, when everyone else is paid and all is said and done, this article is for you. You are definitely not alone, and millions of small business owners in California and throughout the country wrestle with the same types of issues. So, with that said, let’s dive right in:
First Things First. Are you Paying Yourself Correctly?
Many small business owners are not even sure how they should be paying themselves. The way you will be compensating yourself is going to be different based on how your entity is structured:
DBA/Sole Proprietorship. If you are a DBA/Sole Proprietorship (meaning, you have no LLC or no corporation / no S corporation), then there is no business entity. This means that you are the same as the business, and you simply keep what is left over after the payment of all expenses. So, assume that your business makes $100,000 a year, and your expenses are $25,000; then that is a net of $75,000 and that is what you keep. By “keep,” I mean, what you are paying yourself. You will still need to pay: a) federal income taxes; b) state income taxes, c) local/city/county taxes; and d) self-employment taxes. Remember, as a self-employed person, you are responsible for self-employment taxes that are currently 15.3% of income. Self-employment taxes are the equivalent to “payroll taxes” (i.e., FICA/medicare/social security withholdings) for employed persons who receive W-2 wages. So, 4 times a year (each quarter), you will be withholding estimated taxes on your earnings, depositing them with the federal government, and then essentially reconciling taxes deposited versus taxes actually owed when you complete your tax returns each winter/spring.
LLC. If you operate an LLC, whether as a single member or one of several members, chances are that your LLC is behaving, for tax purposes, like a partnership (and has not, for example, taken an election to be treated as a C Corp). As a partnership-based LLC, your LLC probably takes all of the income it receives, pays all expenses, and then distributes a set amount of the net profits to the members on a monthly basis, leaving some amounts in its operating accounts to handle operating expenses. Once a quarter (or annually), or more or less often, as determined by the partners in charge, the LLC probably distributes the unused / unneeded net profits to the members as extra compensation akin to bonuses. Your personal handling of income is going to be the same as though if you were a sole proprietor: of whatever monies the LLC distributes to you, you will be withholding estimated taxes, and pre-paying them 4 times a year, and when tax time comes in the winter/spring, either receiving a refund for overwithholding, or being told you owe more (and penalties for not withholding enough). I should mention here that LLC members generally do not receive income as an employee. An LLC is not permitted to pay “wages” i.e., W-2 type compensation to its members. The reason for this is that there is a specific IRS regulation (84-69) that prohibits LLC members from receiving wages in this fashion. Because LLC owners are business owners, they cannot receive wages as employees. The only exception to this is if the member is receiving what is called “guaranteed compensation” – which is paid regardless of whether the LLC is making sufficient amounts in income to cover such expenses or not. Guaranteed compensation can act as wages and be set off from gross revenues.
C Corp / S Corp
As the owner or shareholder of a C Corp or S Corp, you are considered an “employee” of the business and thus should be paying yourself wages. There tends to be a lot of debate on the Internet about whether owner/shareholders of corporations should be receiving salaries/wages or not, and despite all of the misinformation online, the answer to that question is “yes” – for several reasons, most of which have to do with the structure of the corporate form.
As you probably already know, in a corporation, there is a difference between the owners/shareholders (people who own the business), the directors (those who manage the business and make decisions), and the officers (the individuals who are responsible for the day-to-day operation of the business). The law distinguishes between owners/shareholders that are “passive” owners, i.e., they are not working for the business or actually providing services for the business, versus “working” owners, i.e., those who provide services to the organization, such as its CEO, CFO, etc. Depending on the role of the owner, the owner could be entitled to: a) compensation for “working” (i.e., such as wages, salary, etc.) or b) compensation for passive ownership, such as dividends/etc. As a result, the compensation of an owner/shareholder should be structured accordingly.
So, assuming that you are an owner in a single-shareholder corporation, who runs the business and also owns it 100%, then you should be paying yourself salary/wages for working on behalf of the corporation, as well as compensation by way of dividends/distributions of excess net profits, above and beyond your salary/wages. Many owners add bonuses to the mix as well.
Tax Savings Tips When Paying Yourself as a Business Owner
So, once you have perfected how you should be properly paying yourself, let us now move on to how to reduce your overall tax obligations.
LLCS & DBAS: What is the Best Way to Save Taxes when Paying Yourself as a DBA (Sole Proprietor) or as the Owner of an LLC?
For Sole Proprietors/LLCs, you are probably already aware of the various tax savings tips you can take advantage of, like taking all applicable deductions, contributing to IRAs, and HSAs, etc. Most of these are probably not very interesting, and you probably already know about them.
The problem is that, as long as your business structure is set up in way that causes the withholding/payment of self-employment taxes (like in an LLC or DBA situation), it is generally more difficult to take advantage of tax minimization strategies because self-employment taxes are inherently higher than wage-type (payroll) taxes. So, this creates a situation where you are butting up against the self-employment tax wall that is artificially increasing your tax obligations. What can you do? Strongly consider moving to an S Corporation.
Other ways to reduce overall individual tax obligations when running a DBA or LLC:
- Make sure you are capturing all business expenses, and not for example, missing out of them because of poor document/records retention or memorization
- Maximize your Section 179 Deductions – Read More Here
- Make sure you are taking all applicable deductions – Read More Here
- Deduct the expenses for a qualified “home office” – Read More Here
S Corps and C Corps: What is the Best Way to Pay Yourself as the Business Owner of an S Corp or C Corp?
The best way to reduce your individual tax liability when running an S Corp or C Corp is to make sure you are not overpaying either payroll taxes or self-employment taxes, namely, but compensating yourself appropriately in light of your various roles acting on behalf of the corporation:
Are you Paying Yourself for Services Performed?
The IRS requires owners of S Corps and C Corps to pay themselves a “reasonable” salary. This is going to refer to your W-2 wages. What does “reasonable” mean? It refers to a salary that would ordinarily be considered appropriate given what you are doing on behalf of the business and your level of experience. So, if you have 20 years of experience and are the founder/CEO of your business, it would be inappropriate to pay yourself $25,000 in salary each year, and then push off all of your other types of compensation to non-payroll compensation.
Are you Paying Yourself Bonuses in Excess of Salary?
Bonuses are considered supplemental income, so you will be including them on your personal income taxes for the year. With that said, many small business owners pay out all excess profits from their business entities at the end of each year, to minimize the entity’s tax obligations. So, to give you an example: If your business has net profits of $50,000 at the end of the year, then your business will pay taxes on those earnings (even if they are not distributed to the business owners). When those net profits are distributed to the owners, then the owners will be taxed again on the same income. Doesn’t seem fair, right? For this reason, business owners try to “zero out” the net profits of their businesses, so as to minimize taxes at the corporate level. Using this same scenario and facts, if a business owner knows that the corporation is set to have net profits of $50,000 at the end of the year, in the last few days of the year, they will do a distribution of the $50,000 remaining in net profits to the business owners, and wipe out the tax liability (at the corporate level) on those monies. The distribution obviously will still accrue as income to the business owners and will be subject to estimated tax prepayments, self-employment taxes, etc.
Are you Paying Yourself Passive Income as a Shareholder of your Business?
In addition to paying yourself wages for service rendered to your company, and bonuses of earnings beyond your salary, tax people tend to recommend that you take a look at whether your S Corp or C Corp’s earnings can also be paid to you in your capacity as a passive shareholder. Passive shareholder income is different than your income for services rendered, or bonuses, which again also tie to compensated performance – passive shareholder income compensates you in your capacity as an owner of the business. It would be analogous to the returns you would get for investing in any other entity in the market – if the business does well, the shareholders should see some of those profits.
Why do this? Shareholder income is not subject to payroll taxes – which can save you a significant amount.
Differences in Tax Treatment of Passive Shareholder Income in a S Corp versus C Corp
With all that said, there are important differences in ramifications for paying yourself passive shareholder income in a C corporation versus in an S corporation.
In a C corporation, dividends and shareholder income are not deductible against revenues, meaning that they do not offset your revenues. They are taxable to the corporation. While they will reduce the individual tax liability of the shareholder, by not taking payroll taxes out of that compensation, if characterized as a dividend, that money will have to be paid as income by the corporation. So, the corporation has an interest in characterizing compensation to its shareholders as income subject to payroll, and not a dividend. The corporation generally receives no benefit when making a payment that is characterized as a dividend. So, one of the issues the IRS looks for is whether C corporation business owners are paying themselves too much, and improperly categorizing what should be considered dividends as wage income, so as to obtain a bigger deduction against their revenues. If the IRS can argue that corporate funds were used as compensation or bonus payments, as opposed to nondeductible dividends payments, the IRS can try to argue that more should be paid in taxes both of the corporation and individual level.
In an S corporation, on the other hand, the situation is reversed. With S Corps, the IRS has held that a shareholder’s undistributed share of net profits from an S corporation are not automatically treated as self-employment income which is subject to payroll taxes. So this creates an enormous incentive for owners of the S corporation to characterize net profits as distributions, and not wage-type income, so that they can avoid paying payroll taxes on those profits.
As a result, the IRS requires (as mentioned above), a business owner to pay themselves a “reasonable” salary, which is subject to payroll taxes, so as to be able to justify the amount they’re paying in distribution/dividends which are not subject to payroll taxes. What is considered reasonable? Take the example of the business owner in Watson v. U.S. (DC IA 5/27/2010 105 AFTR 2d). He was a CPA who ran his business, and assigned himself only a $24,000 annual salary, running an S Corporation. He then paid himself over $220,000 in dividends, free of any payroll taxes. The IRS found that his salary was unreasonably low and that hundred and $75,000 of those dividends should’ve been treated as wages subject to employment taxes. So the IRS recharacterize those monies as wages, subject to employment taxes. The percentage they felt was appropriate to characterize as a dividend was roughly 40%. ($99K as “reasonable salary” and the rest as distributions).
As far as taxation of the dividends are concerned, to the shareholder, shareholders of an S Corp are taxed on the allocated portions of the business’s profits – regardless of whether those profits were actually distributed to them or not. Like a partnership, however, a shareholder of an S corporation is not taxed on distributions from the business, as long as, generally, those distributions do not generally exceed the cost basis in the S Corp. This is a very boiled down summary of the rules on the taxability of S Corp distributions. If you really feel like wading into the muck, check out tax guru Tony Nitti’s excellent article on this topic, which goes into the rules in excruciating detail.
Generally, tax people tend to recommend that no more than 25-45% of an S corporation’s overall net profits be payable to you as a dividend in your capacity as a shareholder. The reason for this is, if you allocate too much of your corporate’s net profits to shareholder income, and not enough to wages-type income (subject to payroll taxes), if you get audited the IRS may come to the conclusion that you were trying to skirt payroll taxes by paying yourself an unreasonably low salary.
So To Make a Long Story Short…
- Strongly consider whether to move to an S Corp to save taxes
- S Corps and C Corps:
- Establish a reasonable salary for yourself as an employee
- Pay yourself bonuses to zero out your net profits and reduce your corporation’s net tax liability
- Consider splitting up your compensation to be divided between salary / bonuses / dividends, to reduce your overall payroll tax liability.
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Top FAQs on How to Pay Yourself as a Business Owner
With all that said, because of the amount of misinformation on the Internet (and frankly, non-lawyer and non-tax professionals trying to explain the rules) are a few issues that come up frequently:
“Bonuses Taxed at 25%”
There are a few articles online claiming that you can reduce your payroll tax obligation by paying yourself bonuses instead of extra salary/wages, because bonuses are purportedly “taxed at 25%.” This is not accurate- it blends several different concepts and results in an inaccurate conclusion.
When a Company pays employees bonuses, it has the option to elect to tax the bonus check in one of two ways: 1) an aggregate method by which the bonus check is taxed at the aggregate of the entire amount being paid (salary + bonus), which tends to result in a greater amount being withheld, and hence, cranky employees who feel as though they are receiving less than they expected; or; 2) a flat rate of 25% (federal) for what is considered “supplemental income.”
Withholding, however, is a completely different concept than taxation. Regardless of whether the method that a Company uses to withhold from a bonus payment, the bonus is still taxed as income and still subject to the employee’s same tax rate for purposes of state and federal taxes. As an employee of your business, when you prepare your state/federal income taxes in the winter/spring, your income, as a whole, is taxed and subject to reconcile. So, if you adopted the 25% method of withholding from bonus checks, you may end up owing a little bit in tax liabilities; and if you adopted the “aggregate” method of withholding from your bonus checks, you will probably be entitled to a refund (assume all other things equal).
HSAs, IRAs, etc.
You probably already know that you can reduce your overall income taxes by contributing to tax-deferred health savings accounts, IRAs, and other similar strategies. This article will not go in detail into these strategies.
As a small business owner, you have probably also heard of SEPs, or Simplified Employee Pensions. An SEP is a type of traditional IRA that can be established by self-employed individuals or small business owners, including freelancers. Anyone business owner with at least 1 employee, or any freelancer, can open an SEP IRA, and like traditional IRAs, contributions are tax-deductible for the business, and are not taxable until withdrawal.
As a refresher, the whole point of an IRA is to defer taxation on income until later in life, when presumably your income levels are lower. So, if during your working life you earn $100,000 a year, and contribute $1,000 monthly to your IRA, once you retire and have no income a year, and you wish to withraw your IRA savings at the same amount ($1,000 a month), your tax savings will be the differential between what you would have paid on $112,000 ($100K + $12K, had you not contributed the $12K into an IRA) in income taxes (which would probably been roughly 30%) and $12K a year, which would involve a very negligible amount of taxes. Because the US income tax system is progressive in nature (i.e., the more you make, the more you pay in income taxes), the lower your income for each year, the less you pay in taxes.
With all that said, IRAs are not right for everyone. If your career trajectory is going to involve making more money later in life, or if you do not foresee retiring at the usual ages, then an IRA may not be right for you because your income may not necessarily decrease in your later years. That would defeat the whole purpose of an IRA.
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