11 Oct TAX SAVING STRATEGIES – S-CORP SALARY vs. DISTRIBUTIONS.
TAX SAVING STRATEGIES – SALARY vs. DISTRIBUTIONS.
Every year I get asked by my clients: How can I save money on my taxes and not get in trouble with the IRS? What the right mix of salary and distributions from my S-Corp? Every year, I answer with a slightly different answer because the IRS changes the focus of what areas they audit on a regular basis. One of the many tax saving strategies for S-Corp lies in the way that owners pay themselves, aka salary vs. distributions. The key here is to pay yourself as little as possible in salary and not get in trouble with the IRS.
You might wonder why you would take a lower salary. The answer lies in the self-employment tax (FICA + Medicare). As a S-Corp business owner, you’ve got to pay the employee’s and employer’s portion of the self-employment tax on salary (12.4% for Social Security tax + 2.9% for Medicare tax = 15.3%). If you’re an employee, you only pay 6.2% Social Security tax and 1.45% tax for Medicare.
The maximum Social Security tax for a self-employed individual was $14,694 in 2016. Meanwhile, any money left over after operating expenses, retirement contribution, and salary may be paid out in the form of a distribution from your S-Corp distribution, which costs 0% self-employment tax.
THE RIGHT MIX BETWEEN SALARY AND DISTRIBUTION
The ideal tax situation is to pay yourself $0 salary and the remaining balance in distribution. This avoids paying the 15.3% in self-employment taxes. However, you are still liable to pay state income tax, federal income tax, franchise tax, etc. Unfortunately, you are guaranteed a visit from the IRS if you don’t pay any self-employment tax.
So what’s the right amount of salary to pay? According to the IRS, the right amount of salary to pay depends on industry standards, type of business, and location. The salary must be a “reasonable amount,” which is open to interpretation. A reasonable amount usually equals the median salary someone would earn doing what you are doing at your firm or similar firms.
REAL EXAMPLE – Tax Saving Strategies
Johns CPA, Inc. is an accounting company where John is the only CPA working. In New Jersey, the cost to hire a CPA for tax preparation and audit is anywhere from $90,000 – $150,000 a year. Therefore, a reasonable salary for John is somewhere in this range. In order for John to pay himself this salary range, his company must make at least $100,000 – $150,000 in gross profits! In this scenario, John is very close to paying close to 100% of net profit in salary and not taking advantage of any tax savings.
Most businesses aren’t profitable in their first year of operation. There are startup costs and fixed costs that must be spent. It takes time to build your business and generate revenue. In the above example, it would not be uncommon for the business to need to generate $300,000 in gross revenue before John can pay a salary of $150,000. Paying yourself 100% of net earnings in salary is the safest route to go. But you are paying unnecessary taxes since the IRS definitely allows you to pay yourself a distribution. Therefore, it’s up to you to figure out what ratio is best for you.
Given there is so much subjectivity to what “a reasonable amount” means, the best way to think about how much to pay yourself in salary and distribution is with a ratio + a reasonable explanation
Here’s some reasonable scenarios that have worked well in the past for my clients:
- Unprofitable Business: No salary or distribution (Loss)
- Profitable Business
- A business generating approximately $25,000 a year in net profit, a reasonable ratio would be 100% payroll since there’s not much in earnings to support a distribution.
- A business generating $250,000 a year, a reasonable ratio would be $100,000 payroll and $150,000 distributions, implementing the tax saving strategy.
- For a business that’s doing great, generating over $1M in net profit, you can take a max payroll for $250,000 and a $750,000 distribution. Even through SS tax is maxed out here, there are real savings achieved in Medicare and other payroll taxes for the uber rich.
Paying yourself zero salary and all distribution is obviously the riskiest.
Paying yourself 100% in salary is the safest route to go. But you are paying unnecessary taxes since the IRS definitely allows you to pay yourself a distribution.
YOU NEED TO PAY SOME TAXES
Even though you must pay both sides of the self-employment tax, the upside to being your own boss, besides the amazing freedom and sense of satisfaction you get from creating something from nothing, is you have much more flexibility in deducting expenses, paying yourself in distribution, and contributing more to a self-employed 401k or SEP-IRA up to $53,000.
THE CASE FOR LLCs
The above does not directly apply to LLCs in New Jersey. However, you do have the option to be taxed as a Corporation, and elect S-Corp status, which will give you the ability to implement this tax saving strategy for your LLC.