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3 ways to pay less tax as an S corporation owner
I usually say there are only two ways to pay less tax:
- Make less money (😠)
- Spend more on tax-deductible stuff (💸)
I highly recommend against the first strategy. You are always better off making more money—and yes, paying more tax—than you are making less money. Sure, there are some contrived hypothetical examples of how some combination of federal, state, and local taxes could result in an effective tax rate close to or over 100%, but that's not going to happen in reality.
The second strategy can give us some interesting tax-planning discussion topics. Here I'm lumping actually spending money on business expenses and assets with deferring income (technically not spending money, but it is tying up current cash flow into something you can't touch, at least not without stiff penalties, for a long time, such as a traditional retirement account).
S corporation owners have a third way of paying less tax:
Decrease your salary.
Decreasing your salary reduces the payroll tax—Social Security and Medicare taxes—you pay. (It does not change your income tax, as a reduction in salary creates a virtually-equal increase in passthrough income from your S corporation, so you still have pretty much the same taxable income.)
You can still get that money you would have paid yourself as salary as a cash distribution from the business. (Cash distributions are not subject to payroll tax.)
Most S corporation owners try to keep their salaries as low as possible; in fact, too many don't pay themselves a salary at all.
This is problematic for two reasons:
- The IRS requires S corporation owners to pay themselves reasonable compensation. Failure to do so may lead the IRS to recharacterize some (or all) of those cash distributions as salary. That means owing past due payroll tax on that cash, so you'll also face stiff penalties and interest. Not good.
- The calculations for some tax strategies and benefits are based on how much you paid yourself in salary (distributions don't count). If you don't pay yourself enough (or any) salary, you may not be eligible for those strategies or benefits, which wind up costing you more in the long run.
More on that second point later...
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