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Compensate Yourself Adequately to Build Weatlh

Filed under Personal Finances. Fact checked on May 24, 2012.

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Many business owners fail to compensate themselves for their hard work. Learn what constitutes compensation and which tax-advantaged strategies make sense for your scenario.

Because you're in business for yourself, you can pay yourself what you always knew you were worth, or you can elect to plow cash back into growing your business. Chances are you'll do a little of each. 

Often it comes down to a decision as to what's more urgent: your needs, or the needs of the business. You need to pay your mortgage and feed your kids, but the business may need to meet debt/equity ratios to pacify your bankers. There's also the consideration of how much personal luxury you are willing to forego or defer to achieve stability in your business.

That said, you should consider using your business to compensate you adequately for your efforts. While most of us think of "compensation" as a salary or draw of money from the business, there are many other methods of compensation. Some of these provide significant tax-savings in both the long- and short-term. These methods include:

  • bonuses
  • loans and lease payments
  • fringe benefits
  • retirement benefits
  • life insurance benefits
  • expense reimbursements
  • dividends 
  • delayed compensation

Your Salary and Sole Proprietorships/ Pass-Through Entities

If you operate your business as a sole proprietorship, you will not receive a "salary" or a "draw." Instead, you will report as income on your Form 1040, the amount of net profit or loss from your business (as determined using Form 1040 Schedule C, Profit or Loss from Business.) 

At the end of the tax year, what you do not spend on the business is income to you, even if you put it all into a savings account.

If your business is organized as another type of "passthrough" entity (such as a partnership, LLC or S corporation), all profits flow through from the business to its owners and are taxed once on the owners' tax returns, similar to a proprietorship. For all these types of businesses, your cash compensation level will be dictated primarily by the partnership agreement or by stock ownership and by the cash-flow characteristics of the operation than by tax law imperatives.


Although for wealth-building purposes and tax purposes, the idea of a "salary" is not relevant if you operate your business as a passthrough entity, paying yourself a salary can be very important for asset protections purposes. 

Your Salary and C Corporations 

"Salary" as a means of withdrawing income from your business really applies only to C corporations—or the "regular corporation" that is recognized as a separate legal entity for state and federal law purposes. In a C corporation, the business's profits (after all expenses are deducted, including owners' salaries) are taxed at the corporate level, using the corporate tax rates. Anything left over can be retained by the corporation (with some limitations), or paid out as dividends to the shareholders.

Consider Tax Rate Differences in Setting Salary Amounts

In determining the amount of salary to pay yourself, consider the difference between the corporate and your personal tax rate. If your corporation's tax bracket is lower than your personal bracket, the tax benefit derived from the company's deduction of your compensation will be less than the tax you personally must pay on it as income. 

And if your company isn't turning a profit, there's no tax benefit at all. Conversely, if your corporate bracket is higher than what you think your personal tax rate will be for a certain year, you might consider increasing your compensation.

If you diligently minimize the impact of taxation, your compensation (and wealth) will grow much faster over the years than if you ignore opportunities for tax management. By referring frequently to our discussion on controlling your taxes, you will be able to learn and keep up to date with tax considerations that are beyond the scope of our discussion here.

Bonuses Follow Salary Payments Guidelines

Bonuses should follow the same general guidelines used for salary. Avoid paying yourself a large, last-minute bonus at the end of the year. 

The timing is often as important as the amount when it comes to raising red flags for a tax auditor. Bonuses should be performance-based with parameters established and documented in writing in advance. If the objectives are set in advance, the chances of a charge of excess compensation will be greatly reduced.

If your business is organized as a sole proprietorship, partnership, LLC or S corporation, it's not a bad idea to take a small owner's draw during the year, and then pay yourself a year-end bonus after you know how profitable your operation was that year—making sure to base this on performance and to document it in the business entities records. Regardless of the timing, all the profits will be taxable to the owners.

Compensation Includes Fringe, Retirement and Insurance Benefits

The value of fringe benefits can enhance your total compensation enormously. In many cases, your business can pay for benefits that you would otherwise need to pay for from your personal fund. 

What's more, many benefits have the advantage of being deductible to your business, but not taxable to you. Among the benefits deductible by your business, but excluded from your taxable income, include:

  • medical and dental coverage
  • long-term care coverage
  • flexible spending account salary reductions
  • certain educational benefits
  • group term life insurance up to $50,000


Health insurance premiums for medical benefits provided to partners, proprietors and S corporation shareholders who own more than 2 percent of the stock, and their family members are deductible by the business. Although they are reported as reported as income, they are fully deductible on Line 29 of your Form 1040.

The whole laundry list of fundamental fringe benefits is all very nice, but the real wealth-building benefits to small business owners come in two forms: retirement plans and life insurance.

Savings and Your Retirement Plan

As wealth-building vehicles, retirement plans are hard to beat for providing tax-deferred compensation for you and your employees. Contributions to a qualified plan are deductible by the business, but not taxed to the individual until distributed at retirement when most people are in a lower tax bracket. Plus, income earned on the plan assets accumulates on a tax-deferred basis as well. Moreover, profits can be taken out of a corporation without being subject to tax at the corporate level.

Many small business people think they can rely on the value of their business when they sell it at retirement, thus failing to see the importance of a retirement plan. This is a big mistake for two reasons:

  1. There is no guarantee your business will be worth anything, much less what you expect, when you decide to retire. A willing and able buyer may not be waiting breathlessly on your doorstep.
  2. It's almost foolish to pass up a tax-favored method of reaping the benefits of the time value of money. It doesn't take much to start adding up to sizable sums over a period of years. Uncle Sam encourages you to save for your retirement by leaving these deferrals in the tax laws.

The value of money over time grows geometrically through the "miracle of compounding," if the money is invested and the earnings (in the form of interest, profits, dividends, capital appreciation, etc.) are reinvested rather than distributed out. Consider the following chart:

Growth of $1.00
Years 6% 8% 10% 12% 14%
1 1.06 1.08 1.10 1.12 1.14
5 1.34 1.47 1.61 1.76 1.93
10 1.79 2.16 2.59 3.11 3.71
20 3.21 4.66 6.73 9.65 13.74

For more details about specific types of plans, see our discussion of retirement planning for business owners.

Split-Dollar Life Insurance Can Build Your Wealth

Life insurance can be a significant source of tax-exempt cash. The group-term life policies used as a basic fringe benefit are fine, as far as they go. But in the case of most business owners, the coverage provided is inadequate to meet their financial responsibilities. Yet individual, permanent life insurance is a luxury few can afford to buy with after tax dollars. "Split-dollar" life insurance was developed to fill this gap.

The term "split-dollar" is derived from the fact that the premiums for the life insurance policy on an employee are split between the insured employee and his or her employer. In the most traditional form of split-dollar, the employer pays the portion of the premium that relates to the yearly build-up in the cash value, while the employee pays the portion that relates to the term (pure insurance) protection.

The tax treatment of split-dollar life insurance arrangements is determined under one of two sets of rules, depending on who owns the policy.

  • Employee owns policy. If the employee owns the policy, the employer's premium payments are treated as loans to the executive. Consequently, unless the executive is required to pay the employer market-rate interest on the loan, the executive will be taxed on the difference between market-rate interest and the actual interest.
  • Employer owns policy. If the employer is the owner, the employer's premium payments are treated as providing taxable economic benefits to the executive. The economic benefits include the executive's interest in the policy cash value and current life insurance protection.

Compensation Can Come from Loans, Leases

One widely used method for building personal wealth is for you to retain any real estate used in your business in your own name then lease the property to your company. This gives you income that can be increased in later years as the business prospers. At the same time it gives your company a deduction. 

More importantly, down the road, when the property has appreciated significantly, that appreciation will not be double-taxed as it would if your corporation owned it.


The IRS expressly forbids this method in the context of using a home office. If you want to lease part of your own home to yourself, don't try to deduct the rent on your tax return. You must follow the rules for taking a home office deduction.

This method of leasing property to your business is not recommended for equipment. Equipment is generally leased as a financing alternative. Since equipment doesn't usually appreciate—in fact quite the opposite: it almost always depreciates—there is little benefit in owning it personally.

Use Caution When Taking Loans from Your Business

The temptation for a small business owner to use his company as a bank is a mighty one, and one to be mightily resisted. The owner of a closely held corporation is able to borrow from the company on favorable terms and repay when convenient: these two considerations are usually absent with outside lenders. 

Going the other way, an owner can also make loans to the company and earn a self-determined rate of interest. And the potential for the abuse of these powers inspires the IRS to heightened vigilance in this area.

Loans from a business to an owner can be reclassified as compensation (or, worse yet, as dividends) by the IRS. (If the loan is from your partnership, then it could be re-characterized as a taxable distribution, rather than a non-taxable loan.) Not only will you pay tax on the full amount of the "loan" proceeds, the corporation will be denied the corresponding deduction.

Don't ever consider living off periodic disbursements from your business which you "think of" as loans. You'll get taxed on them, perhaps even with payroll tax penalties, and your company won't be eligible for a corresponding deduction. Many owners, in tough years, try forego taking a salary and just "borrow" enough from the business to live on. The audit risks and increased tax liabilities are significant and not worth it.

In order to avoid reclassification, loans must:

  • must be documented in writing
  • have a set repayment schedule—one that is adhered to, not just a perfunctory piece of paper 
  • an interest rate that can be considered consistent with the going market rates charged by third parties (or the IRS will "impute" a statutory amount of interest)

Expenses Paid by the Business Can Be Legitimate

Legitimate deductible expenses permitted for travel, meals, entertaining clients, automobile expenses and the like, if properly claimed and documented, give an owner many advantages not enjoyed by regular employees. 

Considerable benefit can be gained through the use of deductions for company cars and expense accounts, as long as they are supported by extensive documentation that substantiates their legitimate business purpose.

But often the business owner goes too far and gets into difficulty. The founder, failing to differentiate between himself and his business, plunders the business assets at will. After all, it's his business, so it's his money and he can spend it on himself if he likes, right? 

He's worked hard to build the business up and now he's going to reap the tax-free rewards. Forget compensation on which taxes must be paid, he thinks. He'll just pay his expenses directly out of the company. Or, if he's in a cash heavy business, skim some off the top and not run it through the books.

However, an owner who uses his business to finance his hobbies or extravagant indulgences can expect frequent and costly visits from the IRS.


IRS agents can look at many sources of information, not just the books of the company, for proof of a business owner's spending habits.

The newest wrinkle in audits is called a "lifestyle audit." The type of car you drive, the value of your residence, your travel patterns and general spending habits are all grist for the IRS mill. If your "official" salary and other distributions from your business would not appear to support your lifestyle, you're a sitting duck for severe penalties. While the IRS can conduct lifestyle audits to detect the existence of unreported income, it can do so only if it has information that reasonably indicates there is a likelihood of unreported income. Nevertheless, triggering audits is not a recommended way to build your personal wealth.

Using Dividends Prudently Can Build Wealth

Dividends sound nice. You buy a stock, it pays dividends and you're a happy investor. In fact, if you own a C corporation and the corporation owns stock, a whopping 70 percent of the dividends your company receives from those investments are excluded from taxation (if your company owns less than 20 percent of the company whose stock it holds).

Constructive Dividends

For a privately held company, unless you are prudent and plan ahead, dividends can be expensive and definitely not a cause for celebration. How is this possible, you ask? 

When your closely held company pays dividends to you and your fellow shareholders, you must pay income tax on them, but your company does not enjoy a deduction for them. If you think that's double taxation, you're absolutely right. 

If you own a C corporation and you pay yourself "excess compensation" in salary or bonus in order to distribute profits from your business, the IRS can recharacterize some or all of it as a constructive dividend and render it non-deductible to your company. And, adding insult to injury, they'll likely tack on a non-deductible penalty as well.


An exception to this is a Personal Service Corporation (PSC). Businesses organized as a personal service corporation derive substantially all of their income from the labors of the service provider-owner, therefore virtually everything may be paid out as salary without risk of being reclassified as non-deductible dividends.

Avoiding Employment Taxes

However, if you do plan carefully, receiving income as dividends can actually allow you to keep more money in your pocket (or bank account). Salary payments from your corporation are subject to FICA taxes—Social Security tax of 12.4 percent (6.2 percent by the employer and 6.2 percent by the employee) must be paid on a salary up to $117,000 in 2014. This amount is adjusted annually to reflect inflation, typically increasing the amount.

Also, the Medicare tax of 2.9 percent (1.45 percent each by the employer and employee) must be paid on all salary. Dividends are not subject to employment taxes.

So, if your corporation's tax rate is 15 percent, it might be worth it to pay at least some dividends in lieu of salary. An amount paid as dividends may be taxed twice (at the corporate tax rate, and then again at the individual tax rate) but your salary is essentially taxed twice also (at the combined FICA tax rate of 15.3 percent and again at the individual income tax rate.) But the minute your company's taxable income is more than $50,000, it gets into the 25 percent corporate bracket and payroll taxes look cheap by comparison.


Notice we are talking about your corporation's taxable income, with should be must lower than your actual earnings during the year.

Then there's the rule that if you don't pay your profits out, your company could get socked with an "accumulated earnings tax" which will make you wish you'd just paid it out in dividends and swallowed the double taxation in the first place.

A C corporation can usually retain up to $250,000 without adverse consequences, but a personal service corporation can only retain $150,000. Both types of entities may be permitted to retain amounts in excess of these limits if it can be demonstrated that the additional working capital meets the reasonable needs of the business; for example, if you need to retain cash to buy a new plant and equipment.

There is a happy medium to be struck in your dividend policy. If your firm is profitable, it's usually wise to declare a modest but regular dividend. Think of it as an insurance premium against future audits.

Consider Paying Family Members, Delaying Your Compensation

In the early stages of your business, you may be investing in the business first, rather than realizing any compensation from it. In this instance, it's okay to minimize salary and document your under-compensation for that particular year by noting in your corporate minute books the complete details of why you took less pay than you earned.

Also note that you elected to defer or delay payment until such time as the company can afford to disburse what it owes you. This will help defray contentions of excess compensation in later years.


Bear in mind, if you operate your business as a pass-through entity, all the income of the business flows through to your personal tax return. However, from the asset protection standpoint, it is wise to document what your reasonable salary would be. Then, if you need to withdraw assets from the business to protect them from creditors, you have a pre-existing record of the financial decisions.

There is almost never a problem with this method as long as you:

  • Establish what is "reasonable compensation" for an individual employed at your level, in your industry, and in your area of the country;
  • Document the process at the time you elected to forego compensation in the corporate minutes—including what "reasonable salary" would have been, what you were paid and what amount was deferred; and
  • Documenting the payments when they were made to you and how the corporation characterized them (as a bonus or as a dividend or as a significant raise in salary).

Start-up is a cash-critical phase and even the IRS understands that. And this technique will help you in the event that you decide to take in another shareholder down the road. The debt of the company to you for services already rendered will be duly recorded and will not be in doubt.

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