If you’re an entrepreneur, you know that running a business requires ongoing work and planning. For your business to succeed, the most fundamental elements are to grow revenues and maximize profits. (For related reading, see: A Defined Benefit Plan for Small Business Owners.)
One of the most tempting ways to keep your company expenses low is to pay yourself very little, or even nothing, in the form of W-2 income. While this strategy will definitely lower your payroll expenses and some tax liabilities, there may be potential personal and business costs in the long-run.
And lower wages can help to reduce your business and personal Medicare and Social Security taxes. However, there are a number of other costs to consider:
Impact on Social Security Benefits
Social Security retirement benefits are based upon both the amount of your taxable wages and the number of years you worked, taking an average of your highest 35 years of inflation-indexed Social Security earnings. The lower your taxable income, the lower your future benefits will be.
Also, if you don’t have a full 35 years of Social Security earnings for the average calculation, missing even a few years of Social Security earnings can make a difference. Just one or two years of zero earnings as part of your average can have a big impact upon your future benefits. If you’re not paying yourself much in wages for Social Security purposes, you’ll need to make sure that you’re saving enough to replace that potential loss of benefit income in retirement.
You also need to consider your potential Social Security disability benefits, or lack thereof. To qualify for Social Security disability benefits, you must have at least 40 quarters (10 years) of Social Security earnings. (For related reading, see: IRS Rule on 401(k) After-Tax Dollars.)
Effect on Company Benefit Eligibility
If your company has a benefits plan, a low wage could limit your possible participation. Examples range from immediate benefits such as a matching retirement plan contribution, to asset protection items such as disability and life insurance that may be tied to earned wages. You can purchase individual policies, but be mindful of the fact that the premiums could be substantially higher. (For related reading, see: Is Life Insurance Through Work Enough?)
A Red Flag for the IRS
You could be setting yourself and your company up for a tax audit. Paying yourself less than a fair wage for the services you provide at your company can be an indicating factor for the IRS.
Sale of Your Business
Something that few small business owners think of is how the amount they pay themselves might impact a business sale transaction. You should think carefully about your compensation well in advance of any potential sale. Typically, at least two year’s worth of financial documents will be considered if you decide to sell your business.
- If you pay yourself too much, this impacts the profit on your books, making your business less appealing to potential buyers.
- Conversely, if you’re paying yourself too little, you could be setting yourself up to be under compensated if you become an employee following your business’ transition.
Determining an appropriate amount of taxable wages to pay yourself is only one of the many considerations involved in running a small business. It’s important to take the time to ensure you’re planning wisely for yourself, your business and your family, considering the intertwined financial relationships among each.
The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This article is for informational purposes only. The views expressed are those of SageVest Wealth Management and should not be construed as investment advice. All expressions of opinions are subject to change and past performance is no guarantee of future results. SageVest Wealth Management does not render legal, tax, or accounting services. Accordingly, you, your attorneys and your accountants are ultimately responsible for determining the legal, tax and accounting consequences of any suggestions offered herein.
In accordance with IRS CIRCULAR 230, we inform you that any U.S. Federal tax advice contained in this communication (including attachments) is not intended or written to be used, and cannot be used by a taxpayer, for the purpose of (a) avoiding penalties under the Internal Revenue Code or that may otherwise be imposed on the taxpayer by any government taxing authority or agency, or (b) promoting, marketing or recommending to another party any transaction or matter addressed herein.
The provision of a link to any third party website does not mean that SageVest endorses that website. If you visit any website via a link provided here, you do so at your own risk and indemnify SageVest from any loss or damage incurred.