Small Business

How to Pay Yourself as a Business Owner

November 21, 2019November 21, 2019
How to Pay Yourself as a Business Owner

For corporation owners, calculating a reasonable shareholder salary for themselves is an annual headache.  For one, the salary is directly correlated with their tax burden.  Wouldn’t a savvy owner claim a minimal salary—or in some cases, claim no salary at all—in order to reduce their taxes?

Albeit illegal, this happens often and is a constant point of emphasis for the IRS.  In fact, in 2000, the IRS found almost half-a-million S Corps paid no salary to the owner, essentially bypassing self-employment taxes and costing the government billions of dollars in tax revenue.  S Corp owners aren’t the only ones falsifying their salaries; owners of C Corps, likewise, misrepresent their salary, however, they tend to inflate their calculation in an effort to minimize their corporate tax.  The majority of these owners ended-up paying back-taxes as well as various punitive and legal fees.  

Although it seems easy to lie and misrepresent your shareholder salary, the IRS invests a great amount of time and manpower in reviewing these cases and ensuring their legitimacy.  Although S Corp and C Corp owners have slightly different objectives, an “ideal salary” exists for both cases that will simultaneously reduce the risk of IRS audit and minimize their tax burden.  Calculating this number, however, is undoubtedly difficult.  It’s usually a good idea to consult a legal professional and a tax expert to make this seemingly-arbitrary calculation.

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Salary Regulations from the IRS (or Lack Thereof)

When faced with the task of setting their own salary, most corporate shareholders assume the IRS code has pages-upon-pages of regulations.  In reality, the IRS offers very little in terms of rules or general guidelines, leaving owners to make an informed judgement and hope for the best.  For S Corps, the ideal salary amount would be large enough to avoid an IRS review, yet low enough to reduce pesky self-employment taxes.  For C Corps, the optimal salary will be as high as possible to maximize their corporate tax deduction, but reasonable enough not to provoke an IRS review.  Without experience or guidance however, making the best determination is oftentimes a challenge.

There are a few strategies owners can take in these situations.  First—and perhaps foremost—it’s always a good idea to consult the professionals that are familiar with the unwritten rules.  These typically include business attorneys and tax professionals.  Either route, you’ll want somebody with experience in this area; since there aren’t any codified regulations from the IRS, familiarity with previous audits or compensation disputes is paramount.  

Secondly, reviewing the relevant IRS literature is worthwhile.  Even though the IRS doesn’t offer many specifics, they do mention (in Fact Sheet 2008-25) the factors that should go into making a salary calculation.  These include: 

  • the owner’s duties and responsibilities, 
  • their training and experience, 
  • their time commitment to business-related activities, 
  • any payments or benefits offered to non-shareholder employees, and
  • their dividend history (monetary or otherwise)

Lastly, owners may want to look at similar-sized businesses and make a comparable salary determination based on what others are doing.  Of course, you’re then assuming that other corporate owners are making an informed decision when it comes to setting a salary, which isn’t always the case.

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Tax Differences (and Similarities) for S Corps and C Corps

We’ve briefly mentioned the different approaches taken by S Corp and C Corp owners, however it’s important to remember that both business entities have the same goal in these situations: to reduce their tax burden while remaining within the confines of the law.  Again, this largely comes down to setting their shareholder salary.

S Corps and C Corps are two types of corporate entities.  Both offer liability protections for owners, but C Corps are highly structured and generally meant for larger companies.  S Corps (Small Business Corps) on the other hand, are more flexible in terms of structure and taxation.

For S Corps, the tax that’s levied on the owner’s salary is called a self-employment tax.  In brief, these taxes consist of Social Security and Medicare, and are similar to the Social Security and Medicare taxes withheld from employee paychecks across the country.  As of 2019, these two taxes add-up to 15.3% (12.4% for social security and 2.9% for Medicare).  In other words, whatever salary an S Corp owner sets for themselves will be taxed at 15.3%.  For example, if an owner pays themselves $80,000 when $60,000 could have been a reasonable salary, they’ve unnecessarily exposed $20,000 to the self-employment tax, which equates to $3,060 wasted.  S Corp owners want to minimize their salary to reduce this tax.

Conversely, some C Corps want to maximize their salary to reduce a different type of tax burden.  Basically, this comes down to the distinction between the individual tax rate and the corporate tax rate.  Depending on the tax bracket, some C Corp owners may want to be taxed by their individual rate, not their corporate rate.  One way to drive corporate income to zero is to set high salaries for their employees (including themselves) thereby deducting the payroll amounts from their gross corporate income.  

Like S Corps, C Corp owners cannot set unreasonably high salaries to minimize taxes.  This will certainly provoke an IRS review and perhaps ongoing legal disputes.  Again, there aren’t any “hard rules” offered by the IRS.  It’s incredibly important to involve the qualified professionals when determining your shareholder salary.  The ideal calculation can substantially reduce your tax burden, but an unreasonable salary will oftentimes provoke an audit or review.  

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