Determining the best salary from a tax perspective for an owner-employee of a closely held corporation depends on two factors: first, whether the corporation can accumulate earnings without a tax penalty, and second, whether the Internal Revenue Service (IRS) will disallow deductions on an owner’s salary increase. If your corporation can retain earnings, the best salary level is one for which the combined corporate and individual taxes are lowest. If the corporation cannot accumulate earnings, you should take as much salary as meets the test of the tax code’s “reasonable compensation” standard.
Those guidelines may seem simple, but they become difficult to follow when you consider such factors as the accumulated earnings tax, disallowance of salary deductions, and the 70 percent corporate dividend-received deduction. The basic task confronting owner-officers of a small corporation is to determine the best way to transfer funds from their corporate pocket to their personal pocket.
Here’s a quick guide for finding your best salary. If you can leave earnings in your corporation, your salary should be an amount such that (a) any increase in salary, within reasonable limits, will cost you more in personal taxes than the corporation saves by the additional salary deduction, and (b) any decrease in salary will cost the corporation more in taxes, because of the reduced deduction, than it saves you through reduced personal taxes. And if you must take earnings out of your corporation, you should take a high salary to minimize dividend income that can be taxed at a higher rate.
Keep in mind that “retained earnings” consist of profits held by a company for re-investment in its core business or to pay debt. The IRS wants retained earnings kept to a minimum, because when earnings are paid out as dividends or wages, they’re taxed. When earnings are retained, they generate no tax revenue. The IRS looks to see whether a firm’s retained earnings exceed its “reasonable needs.” An accumulation of $250,000 or less is generally considered within the reasonable needs of most businesses. An accumulation of only $150,000 or less, however, is considered to be within the reasonable needs of a business whose principal function is performing services such as accounting, consulting, engineering, health, law, or performing arts.
To illustrate this, let’s suppose a small corporation has profits of $100,000 per year. The table below compares total taxes at different salary levels for the owner, assuming a personal income tax rate of 28 percent. You can see that the least total tax is paid when the salary is $25,000 per year. That figure will vary depending on how much other income the owner has, and what deductions are available. In real life, the estimate should include state and local income taxes and must steer clear of the $250,000 ceiling on retained profits or an amount within the “reasonable needs” of the business.
If you cannot accumulate earnings, either because of the accumulated earnings tax or because you need the earnings for personal use, then set your salary as high as possible, within reasonable limits. Your salary is deductible by the corporation and helps to reduce corporate profits, thus reducing corporate taxes.
When establishing your best tax salary, remember that frequent adjustments to your salary might flag attention from the IRS, so keep your salary fairly constant from year to year. If your paycheck approaches the “reasonable limit,” find other ways to compensate yourself, such as renting property or equipment to your corporation.
Milton Zall is a freelance writer based in Silver Spring, Maryland, who specializes in tax, investment, and human resource issues.
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