S-Corp Owners Distributions and Pay [E017]

And I feel like it's something that we need to talk about a little bit. So I decided to do an episode. Have you ever wondered how much to pay yourself from your S-corporation? Or have you ever wondered how your distributions are taxed? you know, a lot of times I hear people ask this and they say, you know what?

I've always wondered this, but I've kind of felt stupid to ask. There's no such thing as a stupid question. Right. And I tell people all the time, Hey, I don't claim to be an expert on fixing cars or running the auto repair. You don't need to claim to be an expert on taxes or accounting, but this is why we're here to ask these questions so that you can understand more about your business, allows you to make more money and plan for your future.

But before we get into that, I want to have a quick word from our partners who make business by the numbers possible.

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So when you have an S-corporation there's two major ways that you can take money out of your business. And you can either pay yourself more, right? Give yourself a bonus, put yourself on a salary, or you can take distributions of it. A lot of people, you know, especially new clients that we start working with, it seems to be that both of these amounts have been set at a level and maybe never changed or maybe kind of arbitrary.

And so you need to be taken payroll out of the business. Now what you take out and pay does not actually lower your profit. Well, let me back up a little. It does lower your profit on the business, but remember how S corporations work, whatever money you make on an S corporation flows through to you personally, you pay tax on a personal.

Also, whatever money you take on payroll is reported on your personal tax return and you pay taxes there. And so let's use an example where you have $60,000 in profit from your business. If you have $60,000 in profit on your business, before you take any pay, you can then take $60,000 in salary. The business will shut now shows the Euro profit.

However, remember business profits are going down, which means our payroll income is going to. So personally, we're still going to be paying tax on $60,000 as Corp income goes down, wages go up that $60,000 is still leftover. Same thing. If you split the difference and said, all right, I'm going to take half out on payroll.

Now we have $30,000 in the S-corp $30,000 on payroll. We're still left with that $60,000. This is why, you know, people kind of get confused and you know, we talk about tax planning and people say, we know what I'm going to save money on tax. I'm going to pay myself. not a good idea. As we'll find out here in a second, you're not really saving any money.

You're kind of putting money in your right pocket and putting into your left pocket. End of the day. It's still going to be the same NetApp. Now, one of the things that a lot of people do not consider is even though that there is no income tax break by paying yourself on payroll, there's actually one very big downside here.

Half of that's going to be withheld out of your payroll. The other half is going to be responsible for the employer now in your situation, since you're, self-employed, that's why it comes out to 15% because you're paying both sides of this. So let me back that up for a second, for those that didn't understand them.

So if you look at your pay stub right now, or look at one of your employee's pay stubs, you're going to say. I don't pay 15%. I pay seven and a half percent because that's what you see coming out of a paycheck. But the way the payroll tax works is they kind of split the burden half on the employee and half on the employer.

So the employee pays half and then the employer has to match that same amount. Now, if you're an employee, you pay seven and a half percent and payroll tax. If you're the owner operator and owner of the business, you pay both sides of it because you're an employee and the employer on it. So 15%. Now, like we talked about there's two major ways to take the money up.

We can start with payroll and then the other one is distributions. first question always gets asked on distributions, and this is probably one of the biggest unknown things. So the biggest confusion that we get. How much money do I pay on distributions? How much tax do I pay on distributions? You know, I have a lot of people that are S corporations.

If you're listening to this now S-corporation is what 99% of my clients are. It's the most favorite way to be taxed for most businesses. And people ask this all the time and I say, zero, you are not taxed on distributions. And they say, honey, that doesn't make any sense. I pay tax at the end of the year.

So I'll give you an example. Let's say that you make a hundred thousand dollars in your business. You've already taken payroll. So you have a hundred thousand dollars net income showing on your business and you go and you file your tax return. You're going to pay tax on a hundred thousand dollars of business income.

Now, if you were to say, all right, I made a hundred thousand dollars of income. I'm not going to take a single cent out of my business. I'm all going to leave it all in there. You're still going to pay tax on a hundred thousand. If you take out $50,000 in distribution. You're still going to pay tax on a hundred thousand dollars.

Let's say that you had some previous year earnings in there and you hadn't distributed that money and you decide to take out $150,000 of distributions. You're still going to pay tax on a hundred thousand dollars, whatever you end up doing with the cash after you make that profit does not negatively or positively affect what you're going to pay at the end.

So if you're following the math here, that means that all of the money that you have in your business after you pay taxes on it is yours to do as you please. And so let's say at the end of the year, you have $450,000 in your bank account. Come April. You have a $50,000 tax bill because it was a really good year on it.

And now you're leftover with $400,000 after you take the distribution to pay those pay income tax. You could then turn around that same exact day and write yourself a distribution check for $400,000 and is not going to have any effect on your current year tax return. You've already paid the tax on that money.

Number two is if you don't take any wages. You aren't paying anything to social security. And when you get to 65 or 67, whenever you decide to retire and take social security benefits, you're going to be pretty disappointed at what you get, because you're going to not have paid in anything to social security.

So knowing these two factors, you might still be asking, well, what is a fair and reasonable compensation? Now the magic number that we have most of our shop owners said. It's right around 65 to $70,000. Why 65 to $70,000 is kind of the magic number here is it checks two boxes. The first of which is 65 to $70,000 is a pretty reasonable wage.

No matter where you live now, it's very hard to kind of quantify what a business owner does and what's a comparable wage. But no matter where you are, if you make $65,000, you could argue that you could replace yourself for that position. Now, is that the truth? Do you do way more than that, but sure. If, but if the IRS ever came in, I think we would have a pretty legitimate argument at $65,000 is fair.

Now, when people kind of get into this and there's whole industries about fair and reasonable, competent, Generally don't see any automotive industry on it. There's not really a whole lot of court cases on this getting question. It's not something where the IRS comes in and says, Hey, you took 65. We think that $95,000 is a fair and reasonable amount.

I've also had this question before and saying hunt. I was told in the past that I have to, you know, take half the money out in wages, half the money in distributions. Now, generally not a bad rule of thumb if you want to be conservative on it, but it's not, again, something that's written in stone and something that you have to do.

So the other reason of why $65,000 is a magic number is 65,000 or 65 to 70,000. Is the end of the second gate of social security benefits. So what I mean by that is as you make up to $130,000 on payroll, you're going to be paying into social security and Medicare, the payroll taxes that we talked about.

Once you get over that number, it lowers down a little bit, but just stay with me here. So if you are, as you make more money, Less and less of it is going to go to your future benefits. So for example, if you make $30,000 for every dollar that you pay into social security, you're going to get $4 back in a future.

When you retire. Once you get from 30,000 to $70,000, every $2 that you put in there, you're going to get $2 back. Once you get past that, you're still increasing your social security Bennett. But it's the law of diminishing returns. The next gate, you might have to put in $3 to get $1 back. And then the final gate you're putting in $6 to get $1 back in the future.

It's a very bad return on investment. And that's why we like to hover right around that second gate, because we're getting good bang for our buck. We're driving our future social security benefits. And also we've checked. And get to keep the IRS out of our back out of our business because we're paying ourselves a fair and reasonable amount.

So that business that makes $130,000 a year before he took payroll now makes zero money because he's taken all of that money out in the form of payroll. Now, again, just like before, it's going to lower down your business profits, it's going to raise your personal taxes because of the payroll that you got.

The $130,000 profit is still going to be there, just tax no form of wages. But if you remember before those $130,000 in wages are also going to be subject to that 15% payroll tax. So this person's going to end up paying around $20,000 in payroll tax. Now let's use that same business that just took my advice and says, Hey, instead of taking out $130,000 in.

I'm going to take $65,000 out in wages. So essentially I'm still gonna get the same $130,000 at the end of the year. Just half of it's going to be on payroll and half of it, I'm going to take out in distributions. So if we have $65,000 on payroll, we're now only paying $10,000 in payroll tax. We've cut that payroll tax bill in half.

At the end of the day, you still have the same $130,000. You actually have more. Cause now we save some payroll tax. And we've put money in our pocket, just sheerly by changing a metric of how you pay yourself, pretty straightforward. Isn't it. This is why I tell people all the time, stop giving yourself a raise, stop bonusing yourself. You know, a lot of times, for whatever reason, people have this mental aspect that payroll, a guaranteed paycheck is really what they're striving for. And they think that as the business makes more money and is more profitable, they just keep on raising their wages and raising their wages.

And I tell people all the time, pay yourself 65, pay yourself 70,000. And don't change that as you make more money, that's just going to mean more distributions coming out of your business. Now, another thing that, you know, I was kind of apprehensive to even bring up here cause I try to make things simple, straightforward.

So one of the added benefits of lowering your payroll and showing more profits and taking the money on distributed. As you actually get a tax break on S-corporation earnings. So there's something called the qualified business income deduction. And essentially what it is is qualified businesses, which are, which auto repair shops are.

One of them get a 20% deduction on their S-corporation profits. This is also the same situation if you're a partnership or a sole proprietor, but essentially if you have a hundred thousand dollars of S-corporation profits, you will only pay tax on $80,000. Now S-corp wages, right? Whatever you take out in the form of a business owner do not have this 20% deduction.

So not only by taking more money on a wages, are you paying extra and payroll taxes? You're also foregoing a good deduction on having the money, just be regular S-corporation profits. So if you need it even more push to split this out and to take money on distributions and keep your salary reasonable.

That should be it, that same exercise. I talked about where we had, you know, $20,000 in payroll taxes and down to $10,000 in payroll taxes. Once we took half of it out on payroll and half of it on distribution, probably about another two, $3,000 in extra savings just by having more that money taxes as corporation profits, other than payroll.

So generally when we see this, you know, the way that a profit sharing works is you're allowed to strip off your profits, contribute that to a 401k, get a really good tax break. But one of the ways that you can get more money to the owner and less money to the employees is by making the owners highly compensated and usually making north of $160,000.

So for a retirement 401k plan and opportunities, that would be a good reason to have an increase in your payroll amount. Another one is if the ownership is kind of strange, we see this sometimes. So maybe mom and dad owned the business kid works there. Obviously the kid is not the. But, mom and dad are still the owner on it.

So the kids going to have to take the money out and payroll, you're not going to be able to take distributions because you can only take distributions if you own the business. And then the last one here is partners with different ownership, roles or percentages. So if you have a minority partner that owns 10% of the business, or even they own 60% of it, but you have kind of different.

A lot of times payroll is used to kind of balance everything out. You know, let's say that I went and started a shop and I'm 50 50 with someone, but I'm not going to work there at all. I would expect them to take a decent wage out of there because they're earning that. And then we split the profits afterwards 50 50.

And so there is time and place for messing up payroll and having it above kind of what we call that magic. No. But those situations are few and far between about 95% of the shops that we see should, and usually are taken around 65 to 70,000. Now, if you're sitting here saying, huh, I'm taking $75,000 out and I'm taking $60,000 out, are you saying that I need to go and adjust this?

Maybe you've never taken a distribution out of your business at all. And so here's what I recommend people to do to kind of switch over from all payroll to payroll and distributions. So let's say that you're making, you know, A hundred thousand dollars a year on payroll, you know, taken about $2,000 a week out of the business.

So what I always tell people on distributions is I like distributions to be a one-way street. Meaning when I take that money out, I know that my business is still healthy and still solvent. I'm not going to have to kind of look in the rear view mirror saying. Did I take too much money out? Do I need to put it back into the business?

So I'm gonna take out as little as I possibly need on a weekly or monthly basis, just to make sure I cover my expenses at home. And then what I'm going to do on distributions periodically throughout the year is going to analyze my cash balance. Analyze how much money I have in my bank. And take a larger as needed throughout the year, generally, at least on a quarterly or semi-annual level.

this is something that could be slightly different for everyone. Like I mentioned before, this is the general cases works for almost all people. And this is something that we look at a lot when we're tax planning. But if you're sitting here, think about this, does this make sense for me? This is the question that you should be asking your accountant.

Even if you think you're doing it right of just saying, Hey, is this the right way to do this? Is this okay here? this is something that will save you a decent amount in taxes. And there's really no downside to it to end of the day, like we've mentioned before, you're getting the same amount of money out of this, actually more if you factor in the tax savings, just by shifting around how you're taking some of this money out of your business.

So I hope this was helpful for you. You know, please share this with friends, other people that are self-employed that maybe are struggling with the same thing here. , if you have any questions, comments, or ideas for a future episode, or even if you want to join me on a future episode, please shoot me an email at podcast at dot com.

So, thanks again for joining me on business by the numbers, stay safe and I will talk to you all next week.