The Ultimate Guide to Paying Yourself: Salary vs. Distributions
Hey fellow business owners! Today, we’re diving into the age-old conundrum: "How should I pay myself - salary or distribution?"
Let’s break it down.
The Basics of Salary and Distributions
You’ve got two primary ways to put money from your business into your pocket:
1. Salary/Wages: Just like any regular employee.
2. Distributions: Drawing from the business profits.
No matter how you slice it, it’s all taxable income. So, in terms of income tax, it’s a tie. But here's where it gets interesting.
The Taxation Tango
If you're taking a salary, you'll be saddled with the 15.3% self-employment taxes, covering our old pals: FICA, Social Security, and Medicare. And since you’re both the employer and the employee (such is the joy of business ownership), you’re coughing up for both halves.
BUT! (And this is a big but) If you go the distribution route, those payroll taxes vanish. Say you earn $200,000. As a salary, you'd net around $131,000 after taxes. But with a distribution, you’re looking at a tidy $161,600. A difference of $30,600! Pretty sweet deal, right?
Then you wonder, why not always go with distributions? Well, my friend, the IRS is way ahead of you.
Uncle Sam’s Stipulation
While you might be tempted to dodge the payroll tax by paying yourself solely through distributions, the IRS won’t have it. They know this loophole and have concocted a convoluted rule, scattered across tax codes and regulations, to counteract it.
Here’s the rule in a nutshell: You have to pay self-employment taxes on the value of the services you provide. In layman’s terms, pay yourself a reasonable salary for your job, and then the rest can be distributions.
Determining a 'Reasonable' Salary
This might sound straightforward, but pinning down what's "reasonable" can be a brain-teaser. If the IRS comes knocking, they'll use factors like your role, how you compare to others in your field, the condition of your company, and more.
Let’s play this out. Say you’re a dentist, and you also handle HR and marketing for your clinic. You’d need to consider:
- What dentists with similar experience in your area earn.
- How much an HR manager for a dental chain makes.
- Marketing costs in your locality.
From there, adjust for your unique situation: Do you work less than other dentists? Are you specialized in a niche area? Do you spend less time on HR and marketing than full-timers?
Reality Check
Now, what if your business isn’t raking in enough to cover your "reasonable" salary? No worries! The IRS won’t squeeze money out of you that you don’t have. Pay yourself what you can as a salary and skip the distributions until you reach that salary benchmark.
On the flip side, if you're swimming in profit, pay your reasonable salary, then enjoy the rest as distribution, saving you a chunk in self-employment taxes.
Smart Tax Strategy
Knowing this can be a game-changer for your tax strategy. If you pay yourself below your reasonable salary, thinking you're saving on taxes, an audit could leave you with hefty back taxes and potential penalties.
Similarly, overpaying yourself is just throwing money at unnecessary taxes. Find that sweet spot.
Final Thoughts
Being a business owner is both rewarding and challenging, and figuring out the best way to pay yourself is part of that journey. By ensuring you’re informed and making wise decisions, you'll set yourself up for financial success and peace of mind.
Happy entrepreneuring! 🚀
(This blog article is a much shorter version [written in a much more informal style and devoid of citations] of a chapter in my upcoming book, Law for Doctors: Written So Even Doctors Can Understand. We will announce when the book is published!)