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 $142,800 for 2021. This income limit goes up by around 2% 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 $23,378.4 for 2021.
Meanwhile, 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.
Start Your Own Business
Every business needs their own website. Here’s a step-by-step tutorial showing you how. Not a day goes by where I’m not thankful for starting Financial Samurai in 2009.
I never would have imagined being able to engineer my layoff from a well-paying job in 2012 to just write and be absolutely free. You just never know what might happen if you try.
Back when I started, I had to hire someone for $1,500 to launch FS. Now you can launch in under 30 minutes for less than $50.
Here are some of the best reasons to start an online business, in case you need further convincing. Having a business that can never be shut down, even during a pandemic is quite valuable!
Diversify Your Investments Into Real Estate
If you’re looking to build wealth and save on taxes, consider investing in real estate. The combination of rising rents and rising capital values is a very powerful wealth-builder. Further, the non-cash amortization expense significantly reduces your tax liability on rent.
In 2016, I started diversifying into heartland real estate to take advantage of lower valuations and higher cap rates. I did so by investing $810,000 with real estate crowdfunding platforms. With interest rates down, the value of cash flow is up. Further, the pandemic has made working from home more common.
Take a look at my two favorite real estate crowdfunding platforms. Both are free to sign up and explore.
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the easiest way to gain real estate exposure.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio.