If you own a business, how you pay yourself is just as important as how much. Optimizing your compensation structure can protect you from taxes, increase your cash flow, and ultimately help you keep more of what you earn.
It's important to keep in mind, every situation is unique, so speaking with a tax advisor can help you make informed decisions.
Here are a few strategies to help you optimize your compensation structure.
1. Choose the Right Business Structure
The business structure you pick is key to how you can pay yourself and the tax implications that come with it.
Sole Proprietorship: Simple but with limited options. You take an owner’s draw, which is subject to self-employment tax.
Partnership: Similar to sole proprietorships but can distribute earnings as agreed upon.
LLC: Offers flexibility; you can choose to be taxed as a sole proprietor, partnership, S corporation, or C corporation.
S Corporation: Allows you to pay yourself a reasonable salary and take additional distributions, potentially lowering self-employment tax liabilities.
C Corporation: You are considered an employee, allowing a salary and the ability to take dividends.
2. Distinguish Between Salary and Distributions
If you run an S Corporation, you can pay yourself a salary and also take distributions. Here’s an explantion:
Salary: Subject to payroll taxes, but it shows the IRS you’re paying yourself fairly as a business owner.
Distributions: Usually taxed at a lower rate and not subject to self-employment tax, as long as you have reasonable salary coverage.
Tip: Aim for a balance—pay yourself a salary that matches industry standards while maximizing tax-friendly distributions.
3. Maximize Retirement Contributions
How you pay yourself can affect your ability to contribute to retirement accounts. Here’s what you can do:
Solo 401(k): Lets you contribute both as an employee and employer, maximizing your contributions.
SEP IRA: Offers higher contribution limits; contributions are tax-deductible, reducing your taxable income.
Traditional IRA/Roth IRA: Personal contributions can also affect your tax situation.
Tip: Contributing to retirement plans not only helps you save for the future but also lowers your taxable income for the year.
4. Consider Health Insurance Premiums
If you’re self-employed, you might qualify for a tax deduction on health insurance premiums. This insurance can be paid as a business expense, reducing your overall taxable income.
Tip: Make sure your health insurance plan qualifies for the deduction. Keep detailed records to back up your claims.
5. Use Accountable Plans
Accountable plans let business owners reimburse themselves for business-related expenses without those payments being taxed. This can include home office expenses, travel costs, and meals and entertainment.
Tip: Set up a formal accountable plan that meets IRS requirements for tracking and documenting reimbursements.
6. Track Your Expenses Carefully
Keeping detailed records of all business-related expenses not only helps back up deductions but can also influence how much you can pay yourself. Deductions reduce taxable income, optimizing your overall tax situation.
Tip: Use accounting software or hire a professional to make sure all applicable expenses are recorded correctly.
Conclusion
Fine-tuning how you pay yourself is a smart move that can boost your financial well-being and ease your tax burden. By picking the right business structure, finding the right balance between salary and distributions, making the most of retirement contributions, thinking about health insurance premiums, using accountable plans, and keeping a close eye on your expenses, you can improve your cash flow and keep more of what you earn. Keep in mind, that every business is different, so talking with a tax advisor can give you personalized advice that fits your unique situation.
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