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Sole owner of an S corp? Cut your wages and trim taxes

by on
in Small Business Tax,Small Business Tax Deduction Strategies

If you’re the sole owner of an S corporation, you call the shots. So you can set the salary figures for all employees, including yourself, as long as you stay within the law’s boundaries.

Strategy: Keep your annual salary on the low side. At year’s end, you can pay yourself dividends out of profits.

Why would you skimp on your own salary? You avoid employment taxes on cash distributions from your company, saving literally thousands of tax dollars. Your salary must be “reasonable” under the circumstances or this strategy will backfire (see box below).

Here’s the whole story: The wages paid to you by an S corp are subject to Social Security tax. When you combine the employer’s and the employee’s shares, the 12.4% Social Security portion of the tax applies to the first $106,800 of wages in 2010. The 2.9% Medicare portion applies to all wages.

For instance, if you’re paid $100,000 in wages this year, the combined Social Security tax and Medicare tax bill is a whopping $15,300 (15.3% of $100,000).

But this situation isn’t as dire as it seems. Because you’re in control, you can reduce the employment tax hit without decreasing the amount of money you receive from the S corp each year. It simply requires a judicious adjustment in the amount treated as salary and the amount treated as corporate distributions. Unlike salary, distributions are not hit with the Social Security and Medicare taxes.

Example: Your S corp shows a net income of $125,000 a year. Typically, you pay yourself an annual salary of $100,000, resulting in combined Social Security and Medicare taxes of $15,300. The S corp pays half of the taxes, or $7,650. The other half is withheld from your salary. Then the corporation pays you the remaining $17,350 profit ($125,000 minus $100,000 minus $7,650) as a corporate distribution.

Therefore, you receive $92,350 after paying your half of the Social Security and Medicare taxes ($100,000 minus $7,650) plus the $17,350 distribution, for a total of $109,700 in your pocket after Social Security and Medicare taxes. Of course, you also owe income tax on the wages and an amount of corporate income left after deducting the wages and related taxes (equal to the distribution in this particular case).

Better approach: You’re cutting back on your office hours, so you lower your salary to $60,000.

Now the S corp pays only $4,590 (7.65% of $60,000) in Social Security and Medicare taxes on your wages. At the end of the year, it distributes the profits of $60,410 ($125,000 minus $60,000 minus $4,590) to you. After you pay your Social Security and Medicare tax share of $4,590 (via withholding from your salary), leaving you with $55,410, you walk away with a total of $115,820 in cash ($55,410 plus $60,410). That’s a Social Security and Medicare tax savings of $6,120 ($115,820 minus $109,700)!    

This is a permanent tax break, not just a temporary reprieve, although the benefits may be curtailed by proposed legislation. Note: Using this strategy will result in a slightly higher income tax bill. If you’re in, say, the 25% tax bracket, you’ll pay extra income tax of $1,530 on the $6,120 of savings. But you still come out ahead.

Tip: C corp owners are in a different boat. You may not want to cut salary because profits are hit by income tax twice.

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