One of the simplest ways to cut your self-employment taxes is by receiving some of your income as a distribution instead of all salary.
As an entrepreneur, you are both an employee and a business owner. Payments as an employee require the payment of employment taxes (Social Security and Medicare taxes). The company’s portion and your personal portion add up to 15.3% in self-employment taxes.
However, payments to the business owner(s) through a distribution has no self-employment taxes. In other words, you save the 15.3% self-employment tax.
What Is A Distribution?
A distribution is a form of payment from a corporation to its shareholders. They are essentially periodic payments to the shareholders of the company. C-Corporations like Apple and ExxonMobil provide stock dividends while S-Corporations or LLCs issue distributions. For purpose of this article, we will use S-Corporation to mean both.
Who Is Eligible To Receive A Distribution?
Any shareholder of a corporation is eligible to receive a distribution.
Distributions must be pro-rata (i.e. based on ownership percentage). For example, if there are two 50/50 owners and the corporation made $100K profit last year, you must payout the distributions equally – i.e. each owner would receive $50K.
What are the benefits of paying distributions?
Simply stated, they reduce your taxes.
When you pay distributions, you don’t pay any self-employment taxes (Social Security and Medicare taxes). They are not required to be paid on distributions of earnings and profits from the corporation to its shareholders. Additionally, the corporation doesn’t have to pay the matching payroll taxes.
How Much Can I Pay In Distributions?
While this is a decision left up to owners of the Corporations, it should follow some basic rules. Per the IRS Code, an S-Corporation must pay reasonable employee compensation (subject to employment taxes) to a shareholder-employee in return for the services the employee provides before a distribution (not subject to employment taxes) may be given to the shareholder-employee.
As a general rule, it is advisable to have your S-Corporation pay you at least some salary–which can be on the low end of the reasonableness scale. How low can you go and still pay yourself a reasonable salary? There are no precise guidelines. IRS officials have stated that they make the determination on a case-by-case basis. Among the factors the IRS and courts consider are:
- the duties performed by the employee
- the volume of business handled
- the type of work and amount of responsibility
- the time and effort devoted to the business
- the timing and manner of paying bonuses to key people
- use of a formula to determine compensation
- the ability and achievements of the individual employee performing the service
- the pay compared with the gross and net income of the business, as well as with distributions to shareholders
- the company’s policy regarding pay for all employees, and
- the payment history for each employee.
If you are considering initiating distribution payouts, here are the key points to keep in mind:
1) Zero salary is a red flag. If you worked full-time in your S corp. last year and paid yourself $90K in distributions without taking any wages, that’s a no-no. The IRS notices when owners take no salary.
2) The 60/40 rule. Many CPAs advise their customers to play it safe by following the 60/40 rule: take 60% as salary and 40% as distributions. The basic idea here is that salary should never be less than distributions. This ratio obviously doesn’t apply in every situation but it can be a useful rule of thumb in some cases. You can also determine a “fair” salary by looking at www.salary.com.
3) Distributions cannot exceed profits for the year. This might seem like common sense but, if your company made $60K profit last year then you aren’t allowed to take out $75K in distributions. If you do, things get complicated and you will have to pay capital gains taxes on the excess distributions.
What Do The Numbers Look Like?
We put together a working example below.
*Calculations are estimated and simplified for demonstration purposes.
So, instead of taking the entire $100,000 as a salary, we only took a salary of $50,000. This saved over $6,000 per year in employment taxes. This is a $6,000 tax savings for each and every year you receive distributions.
Act Now And Start Saving on Self-Employment Taxes
If you haven’t been splitting your payments into salary and dividends, don’t feel bad. I didn’t know this either when I started my business. In all, it cost me over $100,000 through the years. It hurts to admit to it in this article. But we can only learn from our past and help others not make the same mistake.
Now that you know about this strategy, meet with your accountant and begin saving on taxes each and every year by taking distributions.
Do you have children under the age of 18? If so, did you know you can hire them and pay them TAX-FREE? Check out: How To Hire Your Children And The Best Way To Do It
Dave didn’t know about this strategy when he started his first business in 2001.