How Much Salary Should a Business Owner Take?

Mark Miller, CPA, Shareholder - Tax   email | bio
August 2011

 
A closely held business owner has tremendous flexibility in determining the amount of salary and bonus to take.  This flexibility, however, is not unlimited. In a C Corporation ownership structure, the IRS might claim that any excessive compensation is a disguised dividend and not deductible to the corporation.  If a business owner takes S Corporation distributions in lieu of reasonable compensation, payroll taxes will be assessed on the amount of distributions deemed to be owner compensation.  Upon audit or challenge, an acceptable level of compensation is determined by facts and circumstances and generally is a very large range.

From a tax planning perspective, the entity ownership structure (C Corporation, S Corporation, LLC or partnership) will have a significant impact on the optimal salary level, but other factors are present as well.  Here are some of the tax and non-tax factors that a closely held business owner should consider in determining how much salary to take.

 C (or "regular") Corporations

C Corporations are subject to a graduated tax rate structure.  The first $50,000 of taxable income is taxed at only 15 percent, and the next $25,000 is taxed at 25 percent.  Therefore, business owners of profitable C Corporations might opt to limit the amount of compensation taken and retain $50,000 to $75,000 of income to take advantage of the lower corporate tax rates rather than zeroing out company income and paying tax at a higher individual income tax rate.

S Corporations

S Corporations are generally not separate tax-paying entities, and their income is passed through and taxed to its shareholders. Therefore, the amount of income to the owner is not affected by the amount of compensation taken. Whatever compensation is taken and taxed to the owner as wages reduces the amount of S Corporation income that is taxable to the shareholder.  Therefore, the S Corporation shareholder is often times motivated to draw out a smaller salary in order to save payroll taxes on any income paid out as compensation. Depending on whether the owner's compensation is below or above the FICA (social security) wage base (currently $106,800), the corporation and owner will save a combined 15.3 percent (2.9 percent if over the FICA wage base) in payroll taxes by taking out S Corporation distributions rather than additional salary.

Personal Service Corporations

A special tax rate structure applies to personal service corporations (PSCs). PSCs are regular corporations for service oriented businesses such as medical, accounting, legal and engineering businesses.  These companies are taxed at a flat 35 percent of any retained income.  Owners of PSCs generally benefit from paying out all profits to the employee-owners as compensation to avoid the higher 35 percent corporate tax rate and potential for future double taxation.

Business Engaged in Research and Experimentation Activities

The tax laws provide a tax incentive (credit) for businesses to conduct research and experimentation activities to encourage innovation and growth.  More and more businesses, especially manufacturers, are engaging in these activities or are hiring experts to determine whether existing activities qualify for the credit.  The R&D credit is equal to 5 to 7 percent of qualifying research expenditures (QRE). In-house wages attributable to qualified research are considered QRE.  Therefore, if a business owner is actively involved in the R&D activities, there is a benefit to paying a larger salary to such owner to maximize the available R&D credit.

Qualified Production Deduction (Section 199)

To encourage domestic production and U.S. job growth, Congress enacted a special tax deduction for businesses engaged in manufacturing, construction, software development and other qualified production activities in the United States. These businesses are eligible for a tax deduction of 9 percent of their qualified production activity income (QPAI). For businesses (or owners) in the top marginal income tax bracket, this deduction equates to about a 3 percent tax credit. Since an owner's salary reduces QPAI, closely held business owners (especially those operating as an S Corporation or LLC) engaged in qualifying production activities should consider reducing owner salaries to increase the available deduction.  

New Wisconsin Manufacturer's Tax Credit

As a part of the Governor Walker's recently enacted budget, Wisconsin has created an offshoot to the federal Section 199 production deduction discussed earlier.  The law creates a domestic production "credit" for production activities conducted in Wisconsin.  The type of eligible business activities eligible for the credit is narrower than the federal deduction and limits the credit to QPAI property assessed as manufacturing and agricultural, and thus excludes  construction activities. This credit will start at 1.875 percent in 2013 and will increase to 7.5 percent of the income from qualifying activities in 2016.  Once fully phased-in, the credit will essentially cause Wisconsin-based manufacturing income to be fully exempt from Wisconsin taxation.  The credit is available to C Corporations and will be passed through to the owners of pass-through entities.   Owner-employees of eligible businesses may benefit from drawing a smaller salary and increasing the business entity's income eligible for the new credit.

Retirement Plan Contribution

If a business owner's company maintains a qualified retirement plan (profit sharing, 401(k), etc.) and makes an employer contribution to the plan, there may be an incentive to increase the owner-employee's compensation.  The maximum amount of owner compensation eligible for an employer contribution in 2011 is $245,000. There are many additional rules and limitations on retirement plan contributions made on behalf of an owner that must be considered, but in general, taking out more compensation will increase the amount the owner can contribute to the plan for his own benefit.

As you can see, there are many factors that come into play in determining the optimal salary amount to pay a closely held business owner. Several of the factors can lead to conflicting motivations as to whether to pay more or less in compensation.  Please consult your Kolb+Co. tax adviser to evaluate the optimal plan for your situation at 272/754-9400.