S Corp Owners Should Plan Their W-2 Wages

There are several reasons why S Corp business owners should carefully plan their W-2 wages. Did you know, there are tax and business consequences when you pay yourself as an S Corp business owner? Let’s review a few reasons why small business owners should plan their W-2s ahead of time.

Before we get started, here is a summarized description of the difference between a salary and an owner’s draw (or simply, a draw):

• Owner’s draw: The business owner takes funds out of the business for personal use. Draws can happen at regular intervals, or when needed.  Draws must be paid in proportion to ownership of the business.
• Salary: The business owner determines a set wage or amount of money for themselves, and then cuts a paycheck for themselves during a pay period.

Here are some of the reasons why S Corp business owner salaries should be planned: 

• Tax savings can be maximized with the right amount of owner wages.
  • An owner’s salary is used to maximize retirement contributions. 401(k) plan retirement plans and S Corp simplified employee pension (SEP) plans require owner salaries. The retirement contribution is based on the owner salary, not owner draw. Tax savings can be realized if salary amounts are properly planned.
  • The IRS requires those who own 2% or more of the S Corp to add self-employed health insurance premiums to box one of their W-2 in order to deduct the cost. The company receives the deduction as wages. Then, the owner’s individual return has a net zero effect because the amount is added in as wages, but deducted out as a separate deduction.
  • Section 199A 20% Pass-Through Entity Tax Deduction. Wages are required to use this deduction to shave 20% off taxable income. Owner salaries may be needed if non-owner wages aren’t sufficient to maximize this pass-through tax deduction. Note that only certain businesses qualify for this deduction. Talk to your tax consultant to see if you qualify.
• An owner’s salary has federal and state tax withholding. The IRS views income tax withholding as being paid evenly throughout the year – even if you pay your taxes in one bonus check at year end. Using tax withholding instead of estimated payments may help a business owner avoid late payment penalties. The regularly scheduled owner’s salary can also be used to pay owner income taxes throughout the year in such a way as to match business cash flow and taxable income.
• IRS has rules about reasonable compensation. The IRS expects that a business owner has a salary that is similar in amount to what would be paid to a non-owner to do the operations-related tasks that the owner does. If a business owner takes too much cash out of the business as an owner’s draw, and not enough in wages, the IRS could audit this issue, re-characterize the draw to salary and assess late payroll tax penalties on the amounts. 
• An owner’s salary can help obtain mortgages or other loans.  Bankers are certainly able to consider both owner draw and owner salary when approving business and personal loans. However, a well-thought-out W-2 salary will help the business owner obtain personal or business loans.
• An owner’s salary allows for value-based owner compensation when a company has multiple owners. S Corp owners must pay owner draws in exact proportion to the percentage of the business they own. If one of the owners works more hours and contributes to the company’s profitability more than the other owner, then their salary can be higher. You must show the IRS that owners are compensated fairly.   
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In summation, take time to plan owner salary amounts. This will help you save money and comply with IRS rules. Owner wage amounts have tax and business consequences, that is why it is important to think through your tax planning strategy, ahead of time.

Mahoney CPAs and advisors are here to help in any way they can. Contact tax consultant and associate director Peggy Prall if you have any questions. 

Read our blog on Pass-Through Entity Tax, for more information on this topic