If you work in your own business, then you should know that you may be able to increase your take-home dollars by carefully planning how you compensate yourself. If you are like most owner-employees, you want to get the most out of your company, and that often means minimizing the amount you must give to taxing authorities. As an owner-employee, you pay not only income tax, but both the employer’s and employee’s portion of the Social Security payroll tax on your own wages, and perhaps unemployment taxes as well. Depending on how your business is organized, you may also have to pay corporate taxes. Giving yourself a large salary may seem like the obvious way to make more money, but there may be other ways to compensate yourself that involve fewer tax implications.
Can you just take cash as you need it?
Generally, you should avoid using your corporation’s coffers as your own personal piggy bank. Simply taking cash out of the till, as needed, is not considered good business practice, and if audited by the IRS, you will owe tax, interest, and perhaps penalties on what you helped yourself to. You may also risk losing the limited liability protections provided by your corporate entity.
Why can’t you just give yourself a salary and collect distributions when the company does well?
Typically, owner-employees compensate themselves with salary and distributions. However, adjusting your salary may help you take more out of your company.
Salary versus distributions in C corporations
You may get more out of your C corporation and pay less to the taxing authorities if you take your share in the form of salary rather than distributions. Your salary is a deductible expense to the corporation and is taxed only once as income to you. However, money paid out as distributions is taxed twice: once as income to the corporation and again as dividends are paid to you. If the money you take from the corporation is paid out in the form of salary, you will avoid double taxation.
For tax years beginning prior to January 1, 2003, dividends were taxed as ordinary income. In an attempt to mitigate some of the burden of double taxation, various pieces of legislation provide that dividends received by an individual shareholder from domestic corporations and qualified foreign corporations are taxed at the rates that apply to capital gains. Most recently, in general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains, and established new rates for higher-income taxpayers. Capital gains and qualified dividends are now generally taxed at 0% for taxpayers in the 10% and 15% tax brackets; at 15% for taxpayers in the 25% to 35% tax brackets; and at 20% for taxpayers in the 39.6% tax bracket. Also, as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.
Caution: Due to these changes, the advantage of salary over dividends may be lessened, depending on your income level and tax bracket. In fact, because salary is subject to Social Security tax and unemployment taxes while dividends are not, it may actually be more advantageous to pay dividends over salary if your business does not need the salary deductions to offset corporate income taxes.
Caution: Don’t set your salary unreasonably high. If the IRS deems your salary excessive, then the excess portion will be taxed as a distribution, and you may be liable for interest and penalties.
Salary versus distributions in S corporations and other business entities
In contrast, if you own an S corporation, you may want to pay yourself a smaller salary and take more out of your business in the form of distributions. Distributions paid out by an S corporation are generally treated as a tax-free return of stock basis and are not subject to payroll tax or self-employment tax (unless they are deemed wages in disguise). Careful planning minimizes what you and your company pay to the taxing authorities and increases your take-home dollars.
If your business is a partnership or sole proprietorship, then these issues have little impact on you. All income will be taxed for self-employment and income tax at the owner level.
Can you take rental income from your own company?
Yes, if you own property that your business can use (such as a building), then rent or lease the property to your company. The lease payments are a deductible expense to the company and provide you with a stream of income that is not treated as salary or distributions for tax purposes.
Caution: However, the terms of the lease must be reasonable, or the IRS could recharacterize the income stream as a distribution.
Can you lend money to your own company?
Yes, and you are allowed to earn interest income from the loan. You loan money to your company, the company gets a lump sum of cash to use in its operations and pays the loan back over time. The loan payments are a deductible business expense for the company, and the company will not have to encumber its assets by posting collateral. You receive repayment of the loan plus interest. Provided the interest rates are reasonable, interest payments will not be characterized as salary or distributions by the IRS.
Caution: To avoid complications, document loans and treat them as arms-length business transactions.
Can you borrow money from your business?
Yes, as long as your company is not publicly held (the Sarbanes-Oxley Act of 2002 prohibits publicly held companies from making personal loans to executive officers and directors). Borrowing money from your business can provide you with economic benefits as well. You avoid much of the time and expense related to conventional borrowing, secure favorable interest rates, and can structure loans that do not require collateral. This leaves your other assets, such as your home, available for other uses.
Caution: As described, you may take advantage of favorable interest rates but not unreasonable interest rates. The IRS has rules regarding insider loan transactions. If your loan does not meet those requirements, it could be deemed something other than a loan and taxed accordingly with interest and penalties. Also, your loans should be documented and treated as arms-length business transactions. This helps you avoid the possibility that loans will be treated as income by the IRS. It also helps you maintain your corporation as an autonomous entity, which is important if you want to avoid becoming personally liable for corporate debts.
How else can you compensate yourself?
There are other ways to compensate yourself as a business owner. Take advantage of employee benefit plans and tax-free fringe benefits, such as qualified transportation expense reimbursement, employee discounts, or de minimis fringe benefits.
You may also provide yourself with a rental income by implementing a sale and leaseback plan. Purchase property from the company and then lease it back. Your company uses the lump sum of cash to fund operations and expansion, and the lease payments are a tax-deductible business expense. Meanwhile, you receive a stream of rental income that is not taxed as salary or distributions, and the leased property retains a residual value.
Caution: Terms of the sale and lease must be reasonable, or the IRS could recharacterize the income stream as a distribution.
If you have questions, contact the experts at Henssler Financial:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
Disclosures: The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
