Consider Taxation When Setting Compensation
According to an annual survey, only about half of small-business owners paid themselves a salary in 2016. Of those who did, the average reported salary was about $76,000.1
Of course, the size of a business owner’s paycheck largely depends on the type of business and how well it’s doing. If the company is new or doesn’t have any employees, the owner’s pay might simply be what is left over after expenses and taxes. Once a business becomes established, hires employees, or has significant profits to work with, the question of compensation becomes more complicated.
Depending on the structure of your business, you generally have two options for taking home a paycheck: a salary and/or a draw (or distribution). As an owner-employee, you pay not only income tax but both the employer’s and employee’s portion of Social Security and Medicare payroll taxes (FICA) on your own wages.
Business Structure Matters
For sole proprietors and partnerships, profits from the business and personal income are treated the same by the IRS. Withholding for payroll taxes does not apply, but essentially you must pay the equivalent in self-employment tax on your reported income at tax time. If you are an officer in a corporation, you must be on the payroll and receive a regular salary subject to withholding for FICA and income taxes.
As the owner of a C corporation, you may pay less in taxes if you are paid in the form of salary rather than distributions. Your salary is a deductible expense to the corporation and is taxed only once as income to you. However, money paid out as distributions is taxed twice: once as income to the corporation and again as dividends are paid to you.
If you own an S corporation, you may want to pay yourself a smaller salary and take more out of your business in the form of distributions. Distributions paid by an S corporation are generally not subject to payroll tax or self-employment tax (unless they are deemed wages in disguise). But keep in mind that IRS rules require compensation to be “reasonable” considering your role and duties.
Regardless of the business’s structure, you may be able to lighten your tax burden by deferring some salary and contributing to a qualified retirement plan. It may also be worthwhile to fund other types of tax-deductible workplace benefits such as life, health, and disability insurance for both you and your employees.