How to Pay Yourself Wisely
Determining reasonable compensation for small business owners involves balancing salary, profit distribution, and fringe benefits while ensuring compliance with tax regulations and maintaining the business's financial health. Here are key considerations and guidelines for setting reasonable compensation:
1. Understanding Reasonable Compensation
Reasonable compensation is the amount typically paid for similar services by businesses in the same area. The IRS scrutinizes this closely to prevent tax evasion through excessive distributions.
2. Components of Compensation
Salary and Wages: The primary form of compensation subject to payroll taxes.
Fringe Benefits: Non-wage benefits such as health insurance, retirement contributions, and other perks that can be tax-advantaged.
Profit Distributions: Payments from profits that are not subject to payroll taxes but can be subject to capital gains tax if distributions are excessive.
3. Factors to Determine Reasonable Compensation
Industry Standards: Benchmark against similar roles in the same industry and geographical location.
Role and Responsibilities: The complexity and scope of the owner’s duties, time commitment, and skills required.
Company Performance: The financial health and profitability of the business.
4. Balancing Compensation and Profit Distribution
Salary: This should be sufficient to cover personal living expenses and reflect the market rate for the owner’s role.
Profit Distribution: This can be used to reward owners but should be balanced to avoid reclassification as wages, which would attract payroll taxes.
Fringe Benefits: Use to reduce taxable income legally while providing value to the owner (e.g., health insurance, retirement plans).
5. Tax Considerations
Payroll Taxes: Salaries are subject to Social Security, Medicare, and other employment taxes.
Capital Gains Tax: Excessive profit distributions, especially if they exceed reasonable compensation levels, can result in capital gains tax.
Loans to/from Shareholders: Must be properly documented and should not be used to circumvent tax obligations. Loans should have a clear repayment schedule and market interest rates.
6. IRS Scrutiny and Compliance
Ensure compensation is defensible with documentation, such as industry salary surveys and job descriptions.
Avoid excessively low salaries paired with high-profit distributions to reduce payroll taxes.
7. Strategies for Setting Compensation
Conduct Market Research: Use salary surveys and industry reports to set a baseline for reasonable compensation.
Document Duties and Hours: Maintain records of hours worked and duties performed to justify compensation levels.
Utilize Fringe Benefits: Maximize tax-advantaged benefits to reduce taxable income legally.
Balance Salary and Distributions: Ensure the owner’s salary is reasonable before distributing significant profits.
Monitor Loans and Repayments: Keep clear records and ensure compliance with IRS guidelines to avoid reclassification as disguised distributions.
Example Scenario
Suppose a small business owner in the tech industry works full-time in their business. Industry data shows that similar roles have a yearly salary range of $80,000 to $120,000. The business earns a net profit of $300,000.
Salary: Set at $100,000, aligning with industry standards.
Fringe Benefits: Health insurance ($10,000), retirement contributions ($15,000).
Profit Distribution: $175,000 is available for distribution after salary and fringe benefits. Assume $50,000 is distributed as profits.
This approach ensures:
Reasonable Salary: Compliance with IRS guidelines, reducing audit risk.
Balanced Profit Distribution: Avoids excessive distributions that could be reclassified.
Optimal Tax Position: Utilizes fringe benefits to reduce taxable income while providing value to the owner.
Conclusion
Setting reasonable compensation for small business owners involves thoroughly analyzing market standards, carefully balancing salary and profit distributions, and strategically using fringe benefits. Proper documentation and adherence to IRS guidelines are crucial to avoid penalties and ensure the business's financial sustainability.