Previously we’ve covered how you can potentially save money on taxes by incorporating your stream as an S-corporation. Please read up on it as there are some rules you need to make sure you’re following to actually get the tax benefit. The core concept to remember is that you wear two hats in your business. One is the owner who is responsible for making business decisions. The other is the employee who is actually providing the labor the business needs to earn income. That employee is paid via a payroll.
One word of warning: This advice is based on the assumption that you’re organized as an S-corporation and the only employees of the business are also owners. If your business has non-owner employees payroll gets significantly more complicated.
A second word of warning: this is something you should work with a CPA to establish. If you need help finding someone who you can talk to about this stuff let me know.
Why establish a payroll
You set up a payroll with a “reasonable salary” so you avoid payroll (or self-employment) taxes. That’s that 15.3% you pay when you’re self-employed. When you’re working for someone else you only pay 7.65%!
You still pay income taxes. Remember that two hat thing I mentioned? The employee doing the labor gets paid via payroll. The owner gets paid on the extra value the business generates above the cost of labor via an owner distribution.
To give myself some easy math to do, let’s say you earn $100k. Yeah I know that’s a lot but it makes the math really easy. Check out what happens if a “reasonable salary” is $50k and you take $50k as an owner’s draw. Normally you’d owe 15.3% as payroll taxes on that $100k if it were all salary. That’s $15.3k! However, if you take half of it as an owner’s distribution you only owe $7.65k in payroll taxes. That’s $7.65k saved which is more than enough to fund an individual retirement account for the year. Not half bad.
Finally, setting up a payroll can make managing your personal finances easier. If you know what you’re going to be getting paid, at least as a baseline, each month you can make a more predictable budget. There is a ton of value in predictability when it comes to finance.
How to establish a payroll
So, now that you see the why let’s get in to the how. The first thing I want to do is take care of a useful rule of thumb. Since “reasonable salary” is such an unclear term you should assume that as a sole owner LLC your salary is at least half of your net earnings. Technically, a “reasonable salary” should be what it would cost to hire someone else to do the work. As you earn more it’s reasonable that you decrease how much you take in salary because the majority of that 15.3% tax phases out once you’re earning more than $127k in 2017. If you’re earning more $200k you’ll pick up an additional 0.9% tax.
There are two main ways of setting up a payroll from your business. The first is to determine your wage ahead of time and set up a regular payout from your business bank to your personal bank. This is probably the easiest way to do it as you can sort of set it and forget it. Additionally, you can set it up to process monthly in your accounting software without having to re-do the math each time.
The second way is to pay yourself based on what you actually earned over your pay period. This is likely to more accurately pay you based on how your business is doing but it’s more work. After all, you need to do the calculations each time you’re paid out. This also means you need to get it entered correctly in your accounting software as a different figure each time.
Potential downsides of decreased salary
While you can save a lot of money in taxes there are some potential downsides to reducing your salary.
- Health Savings Account: If you’re able to contribute to a HSA then it could be more painful to contribute to it via payroll deductions if you’re earning less money!
- Harder to get a house: mortgage companies want you to have a steady income. If you’re self-employed they’re going to assume that your income is less secure than another borrower who works for someone else. I don’t think it’s 100% smart of them to do it this way but it’s how they do it. Some companies won’t count your owner distribution as a “secure” source of income so they’ll offer you worse mortgage terms.
- Retirement account: some of the best retirement accounts available to business owners have contribution limits based on your wages. If you decrease your wages you could decrease the amount you’re allowed to put in the retirement account.
- Social security: Payroll taxes are the taxes used to pay in to Social Security and other government programs. The benefit you get from Social Security is based partially on your income and therefore how much you paid in. If you pay less in tax today you may be getting less of a benefit in the future.
Conclusion
Setting up a payroll on an S-corporation can make your life easier and save you on taxes. It takes some extra administration work but generally it’s worth it. Just make sure to consider some of the potential downsides before committing to it and work with a CPA when you’re setting it up.
You don’t have to figure this out alone. This is what we do- help streamers make great money decisions. If that’s something that sounds interesting to you reach out me or schedule some time for a free consult. You can check out what I do here.
