Every year, as a small business owner, I like to ask my tax accountant: What’s the least amount I can pay myself in salary and bonus before the IRS comes knocking? Every year, he comes up with a slightly different answer. The IRS is smart and is always changing the rules, usually to its benefit.
You might ask yourself, why I would want to be paid the least amount possible by my business? The answer lies in the self-employment tax (FICA + Medicare).
As a S-Corp business owner, I’ve got to pay the employee’s and employer’s portion of the self-employment tax on salary. This equates to a 15.3% tax (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. Spend some time looking at your pay stub next time and marvel!
Social Security taxes are applied to income up to $147,000 for 2022, up from $142,800 in 2021. This income limit goes up by around 2% – 3% a year on average.
There is no income limit to the Medicare tax, and there’s actually an extra 0.9% Medicare tax if you make over $200,000. The maximum Social Security tax for a self-employed individual is therefore $147,000 X 15.3% = $22,491. As a result, self-employed business owners are wondering how little in income they can pay themselves to pay less Social Security tax.
Any money left over after operating expenses, retirement contribution, and salary may be paid out in the form of a distribution. Distribution pays 0% self-employment tax.
THE RIGHT RATIO BETWEEN SALARY AND DISTRIBUTION
If you own an S-Corp, 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, the IRS wants their self-employment tax money and does not allow such a ratio. You will surely be audited if you follow this salary and distribution ratio.
So what’s the right amount of salary to pay? According to the IRS and my accountant, the right amount of salary to pay depends on industry standards.
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.
A Reasonable Amount Salary Example
My company is an online media company and I am the main writer. In San Francisco, the cost to have a writer produce 3-4 quality articles a week is anywhere from $70,000 – $150,000 a year. Therefore, a reasonable salary I could pay myself is somewhere in this range.
But in order to pay this salary range, my company must make at least $70,000 – $150,000 in gross profits! And given you are allowed to pay whatever is left after salary, operating expenses, and retirement contribution in distribution, it’s unreasonable to pay yourself a salary equal to 100% of operating profits given the 15.3% tax.
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 generate traffic and revenue.
Further, you might be running your business out of a lower cost area like China, where the GDP per capita is around $6,800. 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.
I’d like to highlight a combination of ratios and reasonable explanations that could work.
Unprofitable Business: No salary or distribution
A Good Ratio For Profitable Businesses
Let’s say you have a business that is not very profitable. Therefore, it’s difficult to pay yourself a reasonable salary. You might follow a salary:distribution ratio of 1:10. For example, $1,000 salary: $10,000 distribution. The maximum ratio should be 1:1: $5,500 salary:$5,500 distribution. You should be safe.
Let’s say you have a business that generates enough gross profit to pay a reasonable salary: 1:10 up to 1:1. For example, $200,000 salary:$2,000,000 distribution; up to $1,100,000 salary:$1,100,000 distribution. This 1:1 ratio is good, but it’s not going to save you on FICA taxes and Medicare taxes because your salary is way over the $142,800 income limit for maximum FICA tax for 2021.
Let’s talk about these ratios with reasonable explanations.
High Ratio Of Salary:Distribution
At first glance, many people would find a 1:10 ratio pretty risky. It seems like the self-employed individual is trying to avoid paying the self-employment tax. However, if your total operating income is $11,000, you’re not even making poverty wages.
Perhaps your business just got out of being in the red for three years. You pay yourself a token salary of $1,000 because you don’t know at the beginning of the year whether you’ll be profitable.
Only until year end do you realize you’ve been able to squeeze out a profit, and pay yourself $10,000 in distributions.
Now let’s take a look at the business that is just killing it with $2,500,000 in gross profits a year.
Paying yourself $200,000 is a top level salary, even for here in the expensive San Francisco Bay Area.
Therefore, paying what’s left of operating profits after salary, operating expenses, retirement contribution in the form of a $2,000,000 distribution doesn’t seem that unreasonable. It’s not your fault that your business is so good that it makes so much more money than your salary. That’s called leverage.
Finally, let’s say you’re making $100,000 as a freelance physical fitness instructor in addition to your unrelated online media business that generates $500,000 in gross profits a year.
Given you already make $100,000 as a freelance physical fitness instructor, and therefore pay the entire self-employment tax of 15.3%, paying yourself $80,000 from your online media business, with $350,00 left in distribution seems reasonable for a 1:4.3 ratio.
The IRS cares about your TOTAL salary, not just salary from your media business. You should get a self-employment tax refund since you paid self-employment tax on $180,000 of income instead of just $132,900.
Low Ratio Of Salary:Distribution:
According to my accountant, paying yourself a 1:1 ratio is probably the most efficient and least risky way to go. But again, it depends on your overall operating profits and what a reasonable salary is to do your job, which is subjective. Even a 1:1 ratio is subjective. But my accountant has never heard of someone getting audited for paying themselves a 1:1 ratio.
For example, let’s say your business has gross profits of $100,000 a year. Paying yourself $30,000 in salary and $30,000 in distribution with the remaining cash left with the company sounds reasonable living in an expensive city.
If your business had gross profits of $1,000,000, you could pay yourself a salary of $500,000 and distribution of $500,000 too if you have zero operating expenses and don’t play to contribute to a tax advantages retirement account. You’ve already reached the maximum $132,900 salary that faces the 15.3% self-employment tax, so the remaining $367,100 salary is subject to zero self-employment tax.
Most Risky Salary:Distribution Ratio:
Paying yourself zero salary and all distribution is obviously the riskiest. My accountant made one of his clients sign a document saying he advised against doing so. This was seven years ago, and this client hasn’t been audited yet, and he distributes $200,000 – $250,000 a year.
Least Risky Salary:Distribution Ratio
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. Therefore, it’s up to you to figure out what ratio is best for you.
So long as they get their 15.3% tax on $132,900 worth of salary from you, the IRS should have nothing to complain about if you’re giving yourself a very high distribution amount. They’re just waiting patiently for you to start hiring more employees.
The IRS Wants Its 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.
I can’t tell you what the right amount of salary you should pay yourself. This topic should be discussed with your accountant. The salary just has to be reasonable in the IRS’s eyes. You should adjust your salary accordingly each year.
Finally, it’s not like your FICA and Medicare taxes will go to waste. You’ll eventually get at least some of your money back, provided you live a long and healthy retirement.
The IRS will likely be more strict in the future due to the global pandemic. The pandemic has caused big government budget deficits that need to be filled with higher tax collection. Therefore, under a Biden administration, I recommend to be more conservative than aggressive.
If you want to save on taxes, find more reasonable business expenses to deduct. Hopefully, these business expenses will help grow your top line in the future.
Ideally, you want to make so much money from your business that you don’t have to think about the right ratio between salary and distribution to save on taxes.
For example, if you have $1 million in operating profits, you best pay yourself at least the maximum income ($142,800 for 2021) for FICA tax. This way, at least you can feel good knowing the IRS isn’t going to red flag you on this one potential audit item.
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The Right Salary And Distribution Ratio To Save On Taxes is a Financial Samurai original post. I highly advise checking with your tax accountant before making any big tax decisions.
Mark Lawson says
I am the sole owner of a C Corp that has slowed down with negligible earnings. There is a lot of cash in the business that I want to out of the C Corp over time, including for retirement. What is the best way to pay the least amount of taxes?
I’ve been advised that as a single employee and single owner of an SCORP that I cannot contribute to my individual 401k as both employee ($19.5k) and employer (25% of w-2 wages
provided total contributions don’t exceed overall limit), only as an employer.
Is that accurate? I’m not finding anything that supports it online, so just trying to get a confirmation. I am hoping of course I can do both!
Andrew J Warner says
I just read your article. Very interesting!
What about the self-employment taxes on earnings from either an LLC or an S-Corp. Isn’t that also part of the equation and analysis?
Two very confusing things about your article:
1) As a C-Corp owner, if you give yourself a reasonable salary that is above the social security maximum, then what’s the advantage of paying anything the company earns beyond that in distributions? Why not just pay yourself a bonus? You’re taxed at the same rate either way–your highest salary bracket. Your article makes it sounds as if there is a tax advantage in this scenario.
2) Actually, it’s worse to pay yourself a distribution as a C-Corp because you get double taxed–first at the corporate level (a flat 21% now) and then again when you add it onto your reasonable income.
Financial Samurai says
There is none. I’m focused on S-Corp.
Hello, for partnerships, I haven’t found anything thing that says one must take a salary. For partnerships, there appears to be distributions and guaranteed payments. I am a part owner of an Amazon store where all the actual work is performed by a company that we pay; it’s their team and they manage the store. We don’t do anything other than pay the company, renew the license with the company and ensure our bookkeeper and accountant has the info they require. Is a salary required when there’s little to no work involved in our business other than what I described?
tutoring services says
Operating an owner-employee tutoring services firm paying teacher / consultants hourly rate and is a S-Corp. But never made gross profit > $70k in the last 7 years. After expenses, business income was $16k last year. How much is a reasonable salary I can pay myself? I have not filed form 941 so far for the business, but have filed a joint income tax return with my working / salaried wife. Can I file start filing for form 941 starting this quarter without risking penalties from past?
Great article. I have an S-corp (self-defense business) which basically earns no money after expenses and deductions, but allows me to write off many expenses and defer salary and have a pension (401 Uni-K I believe). My corporation has been paying it’s sole employee (me) monthly wages of $3,750 (annual salary of $45K). But this year I’m going to only earn around 1/2 of what I have been earning because I’ll be teaching (working) less. I was thinking that I should / could reduce my salary to $25K. Will this raise eyebrows? I will only teach about 6 hours a week for about 20 weeks a year. Thank you.
Hopefully, you did not transfer ownership of real estate into an S-corporation. That is a massive tax trap waiting to happen when you want to sell the real estate.
You should seek the help of a CPA or tax advisor ASAP.
Financial Samurai says
I did not. But feel free to elaborate more why it would be such a bad idea. Thanks!
Tom Meador says
Per IRS website, and generally understood law (Big 4 accounting firms) “S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee”.
Therefore you must pay yourself reasonable compensation (agreed, that generally IRS will accept median pay for job on BLS (Bureau of Labor Statistics) data, before you can take any distribution.
Just an FYI.
Financial Samurai says
Indeed. I wrote the article. So what’s your definition of a reasonable compensation.
Steven Zai says
Great article breaking down S corp tax status and treatment. I have a quick question:
I opened an LLC and elected S corp taxation status and the only source of revenue for this business will be out of state rental real estate income.
Would this be considered passive income if I have a property manager in place and do you know if the IRS would be ok with me taking the net income as distributions to avoid FICA and Medicare taxes?
A bit off the subject here, but can the employer make 401k contributions from both sources of income (salary and distribution)? Given the tax advantage of taking more income through distribution, would it then make sense to maximize the 401k contribution from the salary rather than the distribution?
How did Steve Jobs manage to get away with a $1 salary?
Dood, el Farbe says
Assuming you’re talking any time after 1980, if Mr. Jobs took a $1 salary it didn’t matter because he didn’t “own” Apple – it was a public company.
Tyler Shick says
Just switched over to an S-Corp and still have a couple of lingering questions that I’m looking for definitive answers on. Any help would be amazing!
I’m taking a $70k salary, all payroll/taxes handled through Gusto. I also want to take a monthly distribution that’s close to my monthly salary.
HERE’S MY QUESTION(s):
How do I prepare for the taxes on my distributions? How do I know how much to withhold? Do I pay quarterly taxes on my distributions?
Distributions fall within your federal tax bracket like other income — they are just free of FICA. The new tax laws also provide an extra tax break for pass-through income on certain businesses, which could reduce your taxable income further. I use Gusto for payroll and quarterly taxes as well, but I still have an actual accountant who files my S-Corp taxes each year and is available to answer questions like these. I would strongly suggest talking with an accountant to get proper guidance and answers to your questions now – not next year when it comes time to file.
Steve Patrick says
Along with the email I just sent, I do get social security income. I could claim that it supports me and that a salary is not necessary or what?
Steve Patrick says
What about all the corporate executives running multi-billion dollar corporations (Mark Zuckerberg, Elon Musk, Larry Ellison and others) who get paid $1 per year? How/why can they escape employment taxes?
This is the most helpful website I have been to this year. Thank you guys! The info here makes one feel like a pro after reading. I just started my business and trying to figure out how much salary to pay myself. I don’t even know how much I will make, I can only estimate.
Steve Adams says
I’ve always planned on the Warren Buffet defense. If the IRS is ok with him getting paid only $100,000 salary, and since I’m probably not quite as good as him, some discount off that seems like a great starting point. :)
Does what you said apply if we are retired and one is 65 and one 70? Our business changed from what it was previously to commercial rental.
Great article, but I’m so confused about something. A few CPA’s have told me that my monthly distribution can’t be an amount that is more than my monthly salary.
For instance, my salary is $2,000 a month after taxes are taken out so they are telling me my monthly distriubition to myself can’t be more than $2,000. WTH??
No one seems to be able to explain to me why this is? Is this even true? For example, if I make about 65,000 net a year and my salary is about 30,000 a year then how much can i take a month for distriubutions?
Financial Samurai says
They are following my recommended 50/50 ratio.
You can do whatever you want, just have to be prepared for an audit.
Also, if you are paying yourself $127,500 in salary… you are paying the FULL FICA tax. Therefore, after you get past $127,500, I think it becomes less of a red flag to pay yourself in distribution b/c it’s taxed the same.
You’re pikers. Depending how much you earn, you should be able to save more than a third on SS taxes, but you need to be a C corp.
1st: Corporate income taxes are 15% on the first 50K in profits. So, make 50K in profits, and pay the rest as a dividend to yourself. If you have no other income, you’ll pay no Federal taxes at all on that income. That’s 42.5k in your pocket. (You can earn 90k in dividends and pay no Federal income tax as a married man. Try it on TurboTax.)
Ah, but you are blessed to have more corporate income than 50K, you say. Time to stop screwing around with Solo 401k and get a REAL retirement plan, a defined benefit pension. You need to get an actuary, but you can throw a LOT of money into the pension annually, and it all goes in from corporate coffers without a dime of tax being paid on it. Oh, and no FICA, either, which is 15.3%. If you’re careful about it, you can dissolve the pension plan and pay it out to the workers, who can roll the money into an IRA. Using substantial periodic payments, you can pay that out without penalty tax, which is only 10%, not 15.3% anyway.
If you’re REALLY bold, you’ll look up subchapter T dividends, and figure out how to avoid double taxation of dividends. But that’s for another time.
cool, now all i need is a business.
Hi looking for a little insight please. The way this is written does this mean distributions don’t get taxed and salaries for self employment do at 15.3% under SCorp status?
Next what about general tax rates like 25% or 28% tax bracket. Do these not need to be paid by the self employed individual?
Figure out how much you need to live per month first, then divide by 2. You can take a distribution up to the amount of your salary any higher and you are asking for trouble. The right salary really is just whatever the dollar amount is so that you can sock away 53000 a year in your solo 401k. Assuming you make that much and dont need to reinvest. I do 4k salary 4k distribution. And then hsa and solo 401k. Salary is technically lower 100s since the hsa 401k and health insurance are all technically salary items that you eventually just write off anyway.
I’ve always found this to be an interesting topic. In my old analyst job, I occasionally would help companies fight the IRS (and the other way around) when it came to “reasonable salary.” Many, many business owners claim a $0 salary and take the rest as distributions, which is just crazy to me.
Jim Wang says
$0 is just indefensible. :)
Yes. In practice, the IRS will not challenge reasonable comp if you hit the FICA limit. One small point on this: Medicare taxes do not have a threshold, the $118,500 is only the FICA limit
Financial Samurai says
Thanks. Have clarified Medicare tax in the post and included the additional 0.9% Medicare tax for income over $200,000. The Social Security tax maximum remains at $14,694 for 2016, which is what many are shooting to reduce even though we supposedly get the money back in the form of Social Security in the future.
Jim Wang says
I get why the ambiguity exists (IRS can’t tell you how much to pay yourself) but I think the current methodology, which amounts to “guessing,” doesn’t make much sense either. You pay yourself what is reasonable… OK, but you might get audited if you don’t pay enough. How much is enough? Well……….
When Bargaineering made more than the $118,500, I just paid myself $118,500 to avoid any type of headache. Was I a personal finance writer? Was I an internet marketer? What exactly was my job title? Who knows? But you can be safe that $118,500 will avoid an audit (In five years, I was never audited due to salary).
So I suppose the IRS got what they wanted. :)
That’s silly. If you get audited the IRS will want to see how you applied the factors laid out in FS-2008-25, not what you paid yourself because you thought it would result in a no change. You should document the factors either way because that is what they will ask for.
Financial Samurai says
Tim, can you elaborate further on your comment? What more does the IRS want if you are paying yourself the maximum income for maximum self-employment tax? I’m arguing in this article that every business owner of an S Corp needs to have a reasonable explanation for the salary and distribution ratio. Thanks
$118,500 is not the maximum. Remember, there is Medicare tax which has no cap.
Also, in some areas, there is corporate tax on distributions, for ex, in NYC. In NYC, as a result, paying out almost everything in salary may sometimes be better than paying the payroll taxes. You can’t win here!
Financial Samurai says
$118,500 is the maximum income for the Social Security tax for 2016. Feel free to check with your accountant or the IRS’s website here. You are correct in that there is no income cap for Medicare tax, and I’ve clarified it in the post.
Sounds like one has to leave NYC! The City tax is a real bummer.
As my accountant and attorney always advise me, don’t let the tail wag the dog. I don’t like paying more taxes any more than the next guy, but for me that’s not the only factor. In fact, in addition to taxes, there is the fact that Manhattan is really unaffordable for most of us.
However, you get what you pay for, so it goes both ways!
Sorry my point regarding the $118k limit was specifically pertaining to Medicare, which I know you mentioned above but in the comment you mentioned “maximum self-employment tax” and I thought you meant both Medicare and SS. My bad!
The IRS wants you to follow the tax code and the method by which you determine your salary is not the same for all types of corporations. The code you use to determine owner income is a separate part of the code than the S-Corp code, so they look at them independently. If they audited you would likely have a positive change, which is why it is silly you would just pay the max to be conservative, because that number is not based on any facts.