Many small businesses are organized as S-Corporations (or S-Corps). There are tax benefits for being organized as an S-Corp as opposed to being organized as a sole proprietor. If you are a sole-proprietor or single member of an LLC, you can elect to be taxed as an S-Corp to get the same tax benefits.
One of the benefits is that the shareholders of the S-Corporation can take distributions. This is just payment to a shareholder that is not subjected to Social Security or Medicare taxes – a savings of 15.3%! You will still owe federal and state income taxes on distributions.
Be cautious, though. The IRS limits how much compensation you can take as a distribution. The IRS does require that shareholders receive wages subject to payroll taxes including Social Security and Medicare. You can’t take all of your compensation as distributions.
Well, how much do you take as payroll and how much as a distribution? This is determined by things like:
- How much net income is the business making?
- What is reasonable industry-standard compensation for a person operating in this capacity?
- What is the shareholder’s basis in the business?
A general rule of thumb is to take 50% of your net income as salary. Another way to say that is to make your gross wages equal to your distributions.
Please consult with your CPA to determine a proper salary for yourself.