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What Should You Pay Yourself?

March 28, 2010

From Barbara Weltman, American Express Open Forum, March 2010

Stories abound about how executives at large financial institutions receive big paychecks and multimillion dollar bonuses. As an owner of a small business, these pay packages are way out of your league. But how much should you be earning from your business? Legal, financial, and tax considerations will affect the answer.

Self-employed versus employee

One of the big misconceptions about owning a business concerns compensation if your business is set up as a sole proprietorship, partnership, or limited liability company. In these cases, you are self-employed – you are not an employee of your company and cannot receive a salary. However, this doesn’t mean you can’t receive regular payments from the business. These payments are called a “draw” and can be fixed at any amount you want or that the business can afford; they have no impact on taxes to your company or you.

If your company is set up as a corporation — whether it’s a C corporation or S corporation — you can receive a salary for work performed for the business. The discussion of how much to take follows.

Financial ability

You can pay yourself as much as the company can afford. The law does not set dollar limits on pay to owners. In good times, owners may take bonuses as well as a salary; in bad times, owners may cut their pay to ensure that their bills, including wages to staff, are paid.

Owners looking for guidance on what to pay themselves should work closely with a CFO or other financial advisor to make sure the pay is appropriate under the circumstances. Owners can also check various websites displaying salaries for work performed, including:

Tax implications

As mentioned earlier, a draw taken by a self-employed owner has no impact on the taxes he or she pays. An owner of a sole proprietorship, partnership, or LLC pays income taxes on his or her share of the profits from the business regardless of whether the money is distributed; the draw does not reduce the profits taxed to the owners. The owners also pay self-employment tax to cover Social Security and Medicare taxes on the same share of profits from the business. Again, the draw does not reduce the amount subject to self-employment tax.

It’s a different story for owners in a C or S corporation. Salary paid by a corporation is tax deductible as long as it is considered reasonable under the facts and circumstances. Only salary payments are subject to FICA to cover Social Security and Medicare taxes.

The amount of salary paid by a corporation may depend on the type of corporation:

C corporations. Generally, owners in these businesses want to receive as much compensation as is reasonable to generate a big tax deduction for the corporation.

This is especially true for “personal service corporations” or PSCs, which are C corporations engaged in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts) where the owner-employees perform services for the business. The reason: PSCs pay a flat 35% tax rate on profits so these corporations often try to “zero out” earnings through salary payments to owners so that there is nothing left to tax in the corporation.

S corporations. Owners of S corporations pay income taxes on salary as well as their share of corporate profits (after subtracting salary payments). Thus, salary payments have no impact on their income taxes. Generally, owners in these entities want to minimize salary payments as a way to keep FICA costs down.

Caution: The IRS is on the lookout for S corporation owners who fail to take reasonable compensation for the work performed as a way to dodge FICA. Talk to a tax advisor to make sure salary payments are adequate under the circumstances. The IRS has provided guidelines on what it considers to be reasonable compensation to S corporation owners.

Barbara Weltman is an attorney and author of  J.K. Lasser’s Small Business Taxes and The Complete Idiot’s Guide to Starting a Home-Based Business. She publishes Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® at http://www.barbaraweltman.com

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