Does your business pay you a fair market salary?
Colorado Business CPA, LLC
February 19, 2017
Analyze your business for its fair market salary!
Most of us, entrepreneurs working in our businesses, tend to discount the value of our time. Many choose to work fifty to seventy hours per week, work weekends, early mornings and nights and often don't count their time as a working time. We create a lifestyle out of it. This is all honorable and fine until one day we will be ready to replace ourselves and the honest realization will hit us. We never pay ourselves the fair market salary due to tax savings techniques, not to mention, we can’t count our time because we might not even know exactly how much time we spent. Therefore, our business numbers can be significantly skewed and we would not even realize it.
People elect their business to be taxed as an S-corporation so they can pay themselves a "reasonable salary". Unfortunately, most of the time that salary is way below how much they should pay themselves, so they save money on self-employment taxes. Then they review their business net income and proudly pat themselves on the shoulder, congratulating themselves on the very healthy net income. "Oh my net income is about 35%, I am doing great," they say. If you look closely to their income numbers, especially if these businesses are taxed as an S-corporation, you would notice that owners’ salary comparing to his or her time invested in the business is actually way below minimum wage. Oops! Once realization hits, you also realize that your business numbers are useless, well the net income and owners’ salary at least.
Therefore, the very first step when I review business reports for S-Corporations, I review owners’ salary and distributions. Why is it important? There are several reasons:
You need to see how much your business actually makes, provided you want to hire someone to replace your position. Will you be paying that person $25,000, $30,000 or $80,000 in salary? What is your reasonable, market salary? How much is the difference between the salary you pay yourself and the market salary? Now, take that difference and subtract it from your net income. How do you like your net income now? For example, let’s examine a law firm, a sole practitioner- attorney, practicing law in his business taxed as an S-corporation. His business generates $150,000 in gross revenue. He is not eager to pay another $6,000 in self-employment taxes, so he pays himself $30,000 in salary. His business net income generates another $50,000 in net income which he takes $30,000 as distribution and leaves about $20,000 or so in the business bank account. looks good, right? IRS is satisfied, or somewhat satisfied, 50/50% salary to distributions ratios are met, his wife works and makes $70,000, so $100,000 is enough for them to cover their living expenses. Life is good. His business generated $50,000 which is 30% on his gross revenue. Looks like a healthy business. Now, let’s take a closer look. How much is the fair market salary for this attorney should he choose to hire someone else to replace himself? Is it $100,000 or $70,000? Let’s say it is $90,000. What happened now? If he replaces his "reasonable salary" of $30,000 with $90,000, his business is actually losing money, he lost more than $10,000 (payroll taxes will increase his loss as well as insurance). His business actually lost the money! Ouch! This is the most misunderstood concept in the real works when it comes to S-corporations.
The second reason is compliance with IRS rules regarding "reasonable" salary. That means if you don't pay yourself a salary that would cover your living expenses, such as mortgage, but pay your mortgage from your business account (even worst, as it related to commingling funds issue), the IRS can audit your business and reclassify your shareholders’ distributions into a salary and will make you to pay payroll taxes, plus interest and penalties. Your reasonable salary amounts should be discussed with your CPA to keep you away from trouble.
Smaller salaries can also prevent you from fully contributing to your retirement accounts, and thus hinder your goals of building wealth for the future by saving money on taxes in the current time.
It also develops a great mindset of a successful business owner.
What is the solution?
Review your annual shareholders’ salary for reasonable amount with your CPA.
Create budget and forecast for cash outflow and projection for taxes and increase in your salary.
Adopt a long-term mindset for success by contributing to retirement accounts as well as satisfying IRS guidelines for a reasonable salary.
Plan your replacement in advance not to be surprised later!
Have questions/ Please call us! 1800-5040-272 ( CPA).
Colorado Business CPA