Paying yourself as an S-corp owner might seem straightforward—just cut yourself a paycheck, right? In reality, it’s a delicate balancing act that could impact your taxes, savings, and compliance with IRS rules. Here’s what you need to know.
Understanding Your Dual Role in an S-Corp
As an S-corp owner, you occupy two critical roles within your business: employee and shareholder. This distinction matters for how you take money out of your company. Employee compensation comes through payroll and is subject to income and payroll taxes. Meanwhile, profits taken as a shareholder—known as distributions—are not subject to payroll taxes. Achieving the right balance between these two forms of payment is crucial.
The Cost of Overpaying Yourself in Wages
A common misconception is that higher wages lower your tax bill. The reality is more nuanced. While wages count as a deductible expense for your business, they trigger payroll taxes—15.3% combined for Social Security and Medicare, in addition to state taxes. For example, giving yourself a $100,000 salary means paying around $15,300 in payroll taxes alone. The tax benefit is offset by this added expense, eating into your profits unnecessarily.
Optimizing with Distributions
Distributions, on the other hand, offer a key tax-saving advantage—they aren’t subject to payroll taxes. However, there’s no such thing as “untaxed” income; S-corp owners still pay taxes on the company’s net profits, whether or not they leave the money in the business. Strategic use of distributions can reduce your overall tax liability and keep more money in your pocket.
Navigating the IRS’s ‘Fair and Reasonable Salary’ Rule
The IRS requires S-corp owners to pay themselves a “fair and reasonable” salary for their work. This prevents owners from avoiding payroll taxes entirely by taking only distributions. Determining what’s fair and reasonable can be tricky; it depends on your role, responsibilities, industry standards, and local market rates. For many owners, a reasonable salary falls within the $60,000-$70,000 range, aligning with what similar roles might earn elsewhere.
Why You Should Care About Social Security Contributions
Contributions to Social Security and Medicare are part of the wages you pay yourself. These contributions matter because they determine the benefits you’ll receive upon retirement. That said, there is a diminishing return on contributions once you exceed certain thresholds, meaning maximizing contributions isn’t always the wisest financial move. The $60,000-$70,000 salary range often balances maximizing benefits while minimizing unnecessary taxes.
Finding the Right Balance for You
To optimize your pay as an S-corp owner, consider the following approach:
- Set a Competitive Salary: Benchmark your salary to industry norms and ensure it fits your role and effort level. This keeps the IRS satisfied and protects you from penalties.
- Cap Payroll Taxes: Once your salary is set, take additional profits as distributions to reduce payroll tax liabilities.
- Plan Strategically for Social Security: Pay enough into Social Security to secure future benefits without overspending.
- Consult with a Professional: Every business and owner’s situation is unique. A qualified CPA can tailor strategies that meet your financial goals.
Common Pitfalls to Avoid
- Paying Too Little: Taking a very low salary or none at all can trigger IRS scrutiny, especially if your business is profitable. If the IRS deems your compensation too low, you could face back taxes and penalties.
- Excessive Wages: Paying too much can lead to unnecessarily high payroll taxes and drain cash flow.
- Ignoring Tax Planning: Your compensation plan should align with your broader tax and business goals. A one-size-fits-all approach rarely works.
By thoughtfully managing how you pay yourself, you can reduce taxes, ensure compliance, and invest more back into your business or personal goals. Talk to your accountant about creating a tailored strategy that works for you.
Are you overpaying yourself as an S-corp owner? Talk to your accountant and ensure your salary strategy maximizes your benefits while minimizing tax risks. For more insights, reach out to us at Paar Melis Associates.
