Small Business Tax Deductions: 4 Critical Steps to Paying Yourself Reasonable Compensation

July 29, 2011 by  Filed under: Taxes 

Are you a shareholder/employee of an S Corporation and not sure how much to pay yourself? This is a common problem and the stakes are high. Pay yourself too much and you’ll end up with a higher tax bill than necessary. Pay yourself too little and the IRS can make your life miserable. This is one small business tax deduction that needs to be done right.

Here are four steps to determining the right amount of compensation.

1. Realize that the compensation must be reasonable. The tax code does not provide a specific formula for calculating your wages or salary, but it does state clearly that you must be paid fair market value (FMV) for the work you do for the corporation. So obviously, if you are working for the business, you must be paid like any other employee (even if you are the only employee). Don’t even think about paying yourself zero wages (which some have tried to do and failed miserably; i.e. they got nailed by the IRS).

2. To determine FMV of your services, find out what others are being paid to do the same kind of work that you do. This isn’t rocket science. Any number of websites provide current wage and salary information for every conceivable job on the planet. If you work full-time, the annual salary of others in your field is a great starting point for this determination. If you work part-time, calculate the hourly rate based on the annual salary of comparable workers and then pay yourself that rate for the actual number of hours you work. It couldn’t be any easier that that, could it?

3. The corporation’s profit (before deducting your wages or salary) isn’t necessarily equal to your compensation. Just because your business has a $100,000 profit doesn’t mean your salary should be $100,000. Your compensation could be less than the profit, depending on the nature of the work you do and/or the amount of time you actually spend on the job. Again, FMV of services rendered should be the main consideration.

4. Don’t forget that any profit remaining after deducting your compensation will legally avoid payroll taxes. This is one of the best built-in tax saving characteristics of the S Corporation. It is what it is. The amount of any payroll tax savings should not be driving your compensation calculation. Rather, you calculate the FMV of your services and then reap the benefits when compensation happens to be less than profits.

Looking for more small business tax deductions? For a free copy of the Special Report “How to Instantly Double Your Small Business Tax Deductions” visit Wayne Davies is author of 3 ebooks on tax reduction strategies for small business owners and the self-employed.

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