As a business owner, you invest a lot of time and effort into making your business successful. But how do you determine how much to pay yourself for all the work you do? This is an important question, especially if you own an entity, where you have the flexibility to decide your own compensation.
In this article, we’ll explore the key considerations in determining how much you should pay yourself, balancing your salary with tax-saving strategies.
Understanding Entity Payments
When you own an entity, your business profits can be divided into two types of payments:
- Distribution: This is a portion of your profits that is not subject to FICA tax, which includes Social Security and Medicare taxes. Distributions are a great way to receive income without incurring additional payroll taxes.
- Reasonable Compensation: This is the salary you pay yourself for the services you provide to the business. Unlike distributions, reasonable compensation is subject to FICA tax.
Why Finding the Right Balance Matters
The IRS closely monitors how entity owners pay themselves because it wants to ensure that everyone is paying their fair share of FICA taxes. If you try to minimize your salary and maximize distributions to avoid these taxes, you could face penalties.
On the other hand, if you allocate too much of your income to reasonable compensation, you’ll end up paying more in taxes than necessary, missing out on potential tax savings. The key is to find a middle ground that satisfies IRS requirements while also optimizing your tax position.
How to Determine Your Reasonable Compensation
Determining reasonable compensation isn’t a one-size-fits-all situation. Here are some factors to consider:
- Job Responsibilities: Your salary should reflect the market rate for someone who performs similar duties. If you wear multiple hats—handling accounting, marketing, sales, and more—your reasonable compensation will be higher than someone who performs just one role.
- Contribution to Revenue: If you are the main driver of your company’s revenue, your compensation should be on the higher side. Conversely, if your role is more supportive, a lower salary might be appropriate.
- Hours Worked: The more hours you invest in the business, the higher your reasonable compensation should be.
Many people suggest a 50/50 split between reasonable compensation and distribution, but this rule of thumb doesn’t apply universally. Every entity is different, and what works for one business might not work for another.
Get Expert Advice
Determining the right balance between salary and distributions requires careful consideration of your specific situation. Consulting with an expert familiar with entity tax strategies can help ensure that you’re paying yourself fairly while maximizing your tax savings.
For further assistance or information, please contact us at [email protected] or 787-473-8985.
Disclaimer:
The information provided is for informational purposes only and should not be considered legal or tax advice. Consult with a qualified attorney or tax advisor to discuss your specific situation.