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:
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.)
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?)
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.
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.
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.
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