Empowering Healthy Business: The Podcast for Small Business Owners

#16 - Owner Compensation Tax & Accounting

June 04, 2024 Cal Wilder Episode 16
#16 - Owner Compensation Tax & Accounting
Empowering Healthy Business: The Podcast for Small Business Owners
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Empowering Healthy Business: The Podcast for Small Business Owners
#16 - Owner Compensation Tax & Accounting
Jun 04, 2024 Episode 16
Cal Wilder

Healthy businesses produce healthy income for their owners. Compensation for business owners can take different forms. This episode discusses the primary forms of owner compensation and associated tax considerations. We also review bookkeeping and reporting considerations for how owner compensation is booked and reported on financial statements. 

More specifically, this episode includes:

  • The primary forms of owner compensation and how they are taxed both on the business and on its owner-employees 
  • How entity type and tax elections impact the taxability of owner compensation
  • S-corporations and reasonable compensation standards
  • How accounting for owner compensation can have a dramatic impact on financial statements and evaluating business profitability
  • Pitfalls to avoid with owner compensation
  • The importance of your CPA utilizing a holistic tax plan to help optimize your tax liabilities

Connect with guest Greg Reed at:

Sponsored by SmartBooks. To schedule a free consultation, visit smartbooks.com.

Thanks for listening!

Host Cal Wilder can be reached at:

Show Notes Transcript Chapter Markers

Healthy businesses produce healthy income for their owners. Compensation for business owners can take different forms. This episode discusses the primary forms of owner compensation and associated tax considerations. We also review bookkeeping and reporting considerations for how owner compensation is booked and reported on financial statements. 

More specifically, this episode includes:

  • The primary forms of owner compensation and how they are taxed both on the business and on its owner-employees 
  • How entity type and tax elections impact the taxability of owner compensation
  • S-corporations and reasonable compensation standards
  • How accounting for owner compensation can have a dramatic impact on financial statements and evaluating business profitability
  • Pitfalls to avoid with owner compensation
  • The importance of your CPA utilizing a holistic tax plan to help optimize your tax liabilities

Connect with guest Greg Reed at:

Sponsored by SmartBooks. To schedule a free consultation, visit smartbooks.com.

Thanks for listening!

Host Cal Wilder can be reached at:

Moderator  00:01
Welcome to the Empowering Healthy Business podcast, THE podcast for small business owners. Your host, Cal Wilder, has built and sold businesses of his own and he has helped hundreds of other small businesses. Whether it is improving sales, profitability and cash flow; building a sustainable, scalable and saleable business; reducing your stress level, achieving work life balance, or improving physical and emotional fitness, Cal and his guests are here to help you run a healthier business, and in turn, have a healthier life.

Cal Wilder  00:35
Welcome. So when we think about healthy businesses, that the owners are making money, right, so one of the reasons you own a business is to generate a healthy income for yourself. In this episode, we are going to discuss the various forms that owner compensation can take, as well as associated income tax considerations, you should be aware of the impact of those forms of compensation, and how to properly account for the compensation in your books and your financial statements. I'm joined again by Greg Reed, CPA and Head of Tax at SmartWorks, who's going to help us break down these issues. Welcome, Greg.

Greg Reed  01:15
Thanks for having me back on.

Cal Wilder  01:17
Sure. So for purposes of this episode, let's assume that our audience is mostly owners of small businesses that are passed through entities so s corpse or LLC is where the owner compensation where the owners control their, you know, their compensation and in spending decisions. And so by pass through, we mean, businesses where the taxable income of the business is reported to its owners on Form K one, and that taxable income is included in the personal tax return of the owners. So for example, you know, a small or midsize marketing agency would be a typical, you know, LLC or S corp pass through entity, right. Venture capital backed or private equity backed companies have different considerations, they may be C corpse, the owners may be different than the executives, the executives may not control exactly their compensation and spending decisions to the same extent as they would in a small closely held business. So with that framework, Greg, let's, you know, let's talk about what are the primary forms of compensation that business owners can receive?

Greg Reed  02:27
Yeah, so there's a couple of ways to get money out of your LLC. And I guess for our conversation purposes, I will say, when I say LLC, I'm referring to s corpse and partnerships. So the first one for specifically s corpse is W2 wages. The second one is distributions. And then you can use some discretionary expenses and fringe benefits to effectively pull money out of the businesses and treat them as as expenses. So, for example, like a home office expense, the business will reimburse you for the home office expenses, and it's a great way to get money out of the business tax free and you get the the expense on the p&l.

Cal Wilder  03:20
Okay, so let's talk about the first form of compensation: W2 wages. So, how are W2 wages taxed at the company level and the personal level?

Greg Reed  03:35
S corp owners are the only owners that can take a W2 wage. Partners in a partnership are not technically allowed to take a W2, even though some some do that technically is not correct in the eyes of the IRS. So something to be aware of, if you are a partner in a partnership, not getting a W2. And treating yourself as a W2 employee in an S corp, you're going to be subject to FICA & Medicare, the same employee and employer level taxes that you would be the paying or your employees would be paying through their W2.

Cal Wilder  04:19
So when the when the S corp, or the LLC taxed as an S corp, writes a paycheck to you as an owner of the of the S Corp. The business pays its half of those FICA/Social Security as well as, I forget whether it's Medicare or Medicaid, but whatever the the FICA and Medicare/Medicaid tax is the employer pays, you know, half of it, six or 7%. And then the employee pays the other half of it another six or 7%.

Greg Reed  04:52
I think the FICO limit is up to, with inflation it might be up to about $160,000 now so once a salary exceeds that you're just paying for Medicare, which is I believe it's only like 2% or so on the employee side. And so it's it's relatively small, but the the FICA, which is the Social Security can be is about 6% for the employee and then 6% for the employer. So you're right, it's half and half.

Cal Wilder  05:30
So the the corporation when it pays wages, pays a corporate level tax. When you add it all up, like you said, the FICA, in the Medicare/Medicaid, and then there's the various, you know, unemployment tax at the state and federal level and other state taxes, I often will say, kind of use a 9% number as the approximate ballpark payroll tax the company will pay on wages that it pays the employees, and then the employees have their own income withholding and, and FICA, Medicare, unemployment, etc.

Greg Reed  06:04
Not a not an exact science, but I'd say that 9% gets you gets you most of the way there.

Cal Wilder  06:12
Great, well, let's talk about distributions. You know, they may be called different things, distributions, distributions of capital, owner draws, dividends, you know, what does that really mean, Greg, and how are distributions taxed at the company level and the personal level?

Greg Reed  06:30
So distribution is just a withdrawal from the business bank account, and a deposit into your own personal bank account. It is a balance sheet transaction. So you're going to reduce your cash and you're also going to reduce your equity, you're pulling equity out of the business, you're essentially making the business less valuable. But it's a great way to pay yourself as an owner, especially as an owner of an s corp because you're not subject yourself to those self employment taxes, right? Those payroll taxes. That's kind of the the true benefit of being an S corp owner. You pay yourself a fair salary, which we'll get into later. But then the balance of that, of what you need to live off of or what you want to pull out of the business, comes out as a distribution or owner draw. I don't like the word dividends. People do use it, but it does have, technically, it has a different meaning. And all those distributions that you take out, are, again, just pulling equity out of the business and not subject to the payroll taxes.

Cal Wilder  07:57
Right, really, it's a non-taxable event for the company, as well as the individual. Although if you think about it, the only way you're really gonna be able to take distributions most of the time is if the business has accumulated profit. And so there is some tax to pay, but it's based on the taxable profit business, not a distribution amount, right?

Greg Reed  08:17
Yeah, there's definitely things to consider when you're pulling a distribution out. If you're not a profitable company, like you alluded to, if there's no cash there, then you can't pull money out. You also probably wouldn't be paid yourself a W2 wage, but you have to be careful of a basis. And basis is your personal equity in the business. Without getting into too much detail, it's essentially what your equity is in the business. And so if your equity in the business is $50,000, and you want to pull out 60,000, then the differential there, the 10,000, is going to be treated as technically a dividend and subject to tax as a dividend.

Cal Wilder  09:08
So in order to be able to pay a distribution in excess of what you've previously invested in the business and the profit that's accumulated in the business, right? In limited ways, that's possible. It is possible that if you were to borrow money, say you drew down your line of credit from the bank, and you borrowed $100,000 from the bank, and then you paid yourself $100,000 distribution you could effectively borrow in order to pay yourself a distribution. Or maybe you've got a business model where customers pay you in advance deposit of some kind, some kind of advanced payment, you know, before you deliver it any goods or services. So, effectively you can borrow from a lender or from customers to raise cash and distribute some of that out of the business, but then you risk running afoul of dividend tax you mentioned and you may drain the company of needed capital at the same time.

Greg Reed  10:04
Yeah, and you can get into the stock basis and debt basis and stuff like that. And that's why you really need to have a CPA on the end that really understands what these terms mean, and how they interact with each other, because otherwise, you could end up getting into a lot of trouble down the road.

Cal Wilder  10:23
Right. So let's talk briefly about the third form of compensation, discretionary expenses and fringe benefits. I know this can be a rabbit hole, especially when it comes to fringe benefits, because taxability and applicability of certain benefits really varies by entity type, whether it's an S corp, C Corp, LLC, partnership, et cetera. You and I, Greg, last summer in episode three of the podcast, we went into some detail about some top tactics that small business owners can use to reduce their taxes, and a lot of that was focused on different forms of discretionary expenses and, and fringe benefits. But could you just kind of summarize how small business owners should think about discretionary expenses and fringe benefits in the context of owner compensation?

Greg Reed  11:17
Absolutely. So I like to say that, you're basically submitting an expense report to the business and getting reimbursed for those expenses, once you submit that expense report, the expense goes on the P&L of the business, and then you get reimbursed and effectively made whole. My favorite one is the home office expense, especially, you know, post COVID, everyone's working from home. And this has become kind of a given with most of my clients that we just automatically take the home office expense, especially for our clients that are in the digital realm that are only working remotely. If you're effectively taking the portion of your home that you use for your your home office, and you're applying certain expenses that you would have paid anyways. So say like electricity, say you take 10% of your electric bill submitted as an expense to the business, it becomes an expense on the business, and you get made whole. So maybe it's $50 a month or, you know, a $20 a month expense. These all add up. Again, we went through a lot of these on that on that past podcast. And so we I don't think we need to dive into it too, too much. But definitely, I would say these discretionary expenses and fringe benefits is where if you have a proactive CPA, you can start to see some solid tax savings opportunities on a year over year basis.

Cal Wilder  13:09
Okay. I would think that might be the the first form of compensation to think about-- how do you maximize discretionary business expenses? Because those would be fully deductible to the business, right? And non taxable to the employee, right?

Greg Reed  13:27
Yeah. And just as long as you're keeping good records, and staying within your means, you know, does it jive and you can't say that your whole house is a home office. But yeah, 10 to 20%, that makes a lot of sense. And it can be a great way to essentially take those personal expenses that you're already paying, and make them tax deductible.

Cal Wilder  13:57
And it doesn't matter the entity type, right? A partnership, an S corp, a C Corp-- they can all reimburse you. Okay. And so, when you're just starting out in business, you're probably relatively small not making a lot of income, it might not really matter, that entity selection. If the business can only afford to pay you $40,000 a year, it might not matter that much whether you're an LLC or an S corp or C Corp, right? But at a certain point, the numbers get bigger and more significant. So what what would you say Greg, about entity selection when it comes to compensation and which entities and forms of compensation might be more tax advantaged than others?

Greg Reed  14:51
Yeah, that's a great question. So it kind of depends on the industry and how your compensation would be for your specific job. But there's typically a threshold where it makes sense to go from either a single member LLC we would consider like a Schedule C on your individual income tax return or a partnership, to electing as s corp. And the reason for that is because your single member, LLC, on your personal tax return, or your partnership, all that income that passes through to you, and your pay at the individual level is going to be subject to self employment taxes. Effectively, all self employment taxes are payroll taxes, but it's the both the employer and employee side of it. So you're looking at about 15% of whatever you earn being tax in addition to the the income taxes. What happens is, a lot of people will say, "Oh, you know, what, I'll just assume 25%, of whatever I earn is subject to tax, it's a good number, it'll get me most of the way there." And then all of a sudden I prepare the tax return. And they're like, "Well, why do I have all this extra tax on my tax return?". It's because of the self employment taxes. Now, like I said, there was a threshold. So at 30,000 or 40,000, it's not a huge number. And it probably doesn't make sense. And if I see, say, 30,000 or 40,000 of bottom line net income, it probably doesn't make a ton of sense to convert to an s cor, potentially create another filing, another fee that you have to pay your CPA to prepare return, set up payroll, run payroll, go through all that headache, just to save what might only be, you know, a couple thousand dollars. But to your point, if now we're hitting maybe 70,000-80,000 in bottom line net income, it might make sense to convert to an S corp, pay yourself a salary of call it 40,000-50,000 and then pull out the remainder of, of what you need to live off of, say, another 10,000,-15,000 as a distribution. You're effectively saving 15% on that 10,000-20,000 that you're pulling out of the business over and above the wages that you're paying yourself. And as you you know, go from say that 50,000-60,000 of wages that up to the FICA limit, right? That's where like you maximize the tax savings as as an S corp owner.

Cal Wilder  18:27
And so it'd be very tempting, it sounds like if I'm an S corp owner, to pay myself a very low salary, because all the extra distributions would not be subject to self employment tax, right? But that sounds too good to be true. So what do we need to worry about there?

Greg Reed  18:45
It would be very tempting and sometimes it is a little too tempting for for some business owners. The IRS is on to us. They agree that this is a legal way to to pay yourself and pull money out of a business. But you cannot treat yourself as an S corp and pay yourself $12,000 a year as a CEO of a business. You have to pay yourself what the IRS loosely defines as a fair salary. Now, the tax code does not specifically define how to come up with a fair salary, what a fair salary is, there's no percentages. There are some industry standards that that I've used, and there's there's kind of different levels on how to come up with that salary. So I think a lot of CPAs will use a 60%/40% split. Whatever your take home needs to be, let's just say 100,000. So 60,000 would be your wages 40,000 would be distributions. Does that make sense? Again, depends on what you do, you can get super detailed, there are programs out there that will kind of walk you through a list of like a questionnaire and say, what do you do for the business? How much time do you spend doing each activity? Maybe to the point where they're like, are you doing janitorial services versus CEO level services, right? Obviously, those two areas are gonna get paid a different salary. So it takes all that into consideration. It takes into consideration your geographical location. And it'll spit out basically an audit proof summary of what you should pay yourself. In my experience, what I've seen is, if you have a good CPA, they can pretty accurately come up with what a fair salary is. For a lot of people, you know, you kind of kind of know what it would be, right? And you can try to cheat it and go super low, but eventually, you'll probably get get whacked.

Cal Wilder  21:39
So let's, let's talk about the business that has grown and become significantly more profitable. Where instead of talking about $50,000 or $100,000 of annual owner comp, we're talking about $250,000, or $500,000, or a million dollars or more, right? So what's the threshold these days?

Greg Reed  22:01
Call it $160,000 for now, although I think that's just a round number after inflation every year.

Cal Wilder  22:11
So if you've got a larger business, and you're the CEO, and the business is doing a half million or more in annual profit, it's gonna be very hard for you to justify a salary significantly lower than that FICA threshold, right? And so then you're really looking at self employment tax of 2.9% or so on the Medicare and Medicaid to worry about, which is, you know, at smaller salary levels isn't very meaningful. But if you're talking about $500,000 of taxable income, you know, 3% of that is $15,000. So, you start to worry about the Medicare/Medicaid portion of the payroll tax.

Greg Reed  22:57
Yeah, I mean, again, there's a law of diminishing returns here. Once you get over that FICA limit, it becomes less advantageous. But it is still, you know, if someone handed you $15,000, would you say no to it? Probably not. I certainly wouldn't. And so it's still a tax benefit, just not a huge tax benefit. And again, it it really depends on a lot of it depends on your geographical location. You know, maybe some of the southern states $125,000 could be a fair salary, and now you've got that $30,000-$40,000 gap between $125,000 to $160,000, that you're getting kind of the maximum benefit on.

Cal Wilder  23:59
Okay, makes sense. So, let's talk a little bit more about fringe benefits. What are what are the top several types of fringe benefits that you see? And how are those subject to tax? What do you need to provide your CPA so the CPA can incorporate them properly in your tax return?

Greg Reed  24:25
Yeah, I think the biggest one would be be like health insurance, which can get a little dicey. I think fringe benefits in general, especially for S corp shareholders, or S corp owners can get can certainly get tricky, and certainly something that you want to discuss with your your CPA. So for example, I mentioned health insurance and guaranteed premiums, those technically aren't deductible from a for greater than 2% shareholder. And so you have to make sure you set up your payroll correctly. And you have to make sure that you're preparing your individual income tax return correctly to take advantage of those deductions if you can, at the individual level.

Cal Wilder  25:22
All right. So we're talking a lot about how owner compensation is taxed, especially between the different entity types. I'd like to talk a little bit about a related topic, which is how owner compensation is accounted for. How do you bookkeep it? How do you book it in QuickBooks? Where does it get reported in your monthly financial statements? Right? And I think before we dig into that particular topic, I think there's a kind of a context, an issue around book-tax differences we need to understand. So I come at things from more of a management reporting perspective, where I want the owners and executives of the business to have as accurate as possible a snapshot of how the business is performing financially so they can use that information to make management decisions. And I tend to devalue the tax return. Because I think, well, yeah, you have to file the tax return at the end of the year. And I know a lot of work and skill goes into the tax side of it. But I really care, first and foremost, about running a nicely profitable business. And then I'll let the tax project figure out how that needs to get reported to the IRS. But I know inevitably, there's some differences between priorities of managers in management reporting and priorities of owners when it comes to their taxes and their CPAs and helping them plan and file their taxes. So what is this concept of book-tax differences? And where does it often arise?

Greg Reed  27:07
So I think what you typically would like to see is if an owner is going to pay themselves or needs, let's just say they need $150,000 to live off, you want to see the 150k on the P&L or the income statement. So you can accurately show, okay, here's your monthly net income, here's your available cash. It provides a much cleaner snapshot otherwise. From a technical tax standpoint, you're only going to deduct your W2 wages from the income statement. And any distributions are going to be a draw from equity on the balance sheet. And at a given snapshot throughout the year, you might not necessarily really appreciate where you are financially as a business owner. Your p&l might look awesome. But if you're taking a ton of distributions out of equity, then you're your business might not be doing that great from a cash flow perspective. And I think those are the book-to-tax differences that we as tax preparers and accountants need to make sure that we just communicate to each other. I know you and I have gone back and forth on how these get reported and where they get reported. And I've always said, if you want to put distributions throughout the year on the income statement, although technically not correct,

Cal Wilder  28:59
from a tax perspective, 

Greg Reed  29:01
from a tax perspective, if you're going to do it, make it a separate line item and put flashing red lights around it and warning signs and just so that when the CPA gets the books, they know okay, I see what the accountants did here. And I understand why they did it. But let's make it correct in the eyes of the IRS, right. Or I guess you could argue GAAP as well. But, you know, we're not necessarily following GAAP for all our clients.

Cal Wilder  29:38
So let's talk through an example to help crystallize this for the audience. Let's say we've got a business doing a million dollars in annual revenue. And the owners taking $150,000 distribution or draw or whatever they call it, distribution in a partnership, in an entity like an LLC that's filing as a partnership. And so we have a million dollars of revenue, $150,000 of distribution. And so why this really matters is let's say the $150,000 in QuickBooks is reported as an equity distribution like it would be on the tax return. So we've got a million dollars of revenue and say QuickBooks says, at the bottom of the p&l, a profit of $100,000 for the year. Now looking at that, you might say, Oh, great, a million dollars of revenue, I got $100,000 of profit, I made a 10% profit margin. That's pretty good. Life is good. I've got a nice, profitable business. But what about that $150,000 of distribution that you got paid for being the CEO of the company, that you would have to pay somebody else to do if you were not the CEO of the company. So there's kind of $150,000 of operating expense that appears nowhere on the p&l. But let's say we took the alternative approach. And we booked the distributions as an expense on the p&l. And we used a separate account in the Chart of Accounts, we highlighted it in yellow when we communicated with the CPA, we highlighted it. But let's say we look at that p&l, now. We've got a million dollars of revenue, and we subtract out the $150,000 of owner distribution. Now, instead of having a positive $100,000 at the bottom of the p&l and feeling happy like we made a 10% profit margin, we're gonna have negative $50,000 at the bottom that p&l. And we're gonna be unhappy because we lost money, and we've got a negative 5% profit margin. And so that's why it really matters for management reporting is. You know, what was the real operating expense and p&l of the business? Not just what is the tax returns, say. So that's why this really matters.

Greg Reed  32:02
And if you're an accountant, and you're doing this, you would look like an absolute rockstar, if you turned around and said, Well, maybe we have some basis issues that you should be documenting your CPA about. Because if you're negative 50,000, with the owners comp, then you're effectively pulling out more equity from the business, then potentially you you have, and you could run into basis issues. So a little thing for the accountants out there that could make yourselves look like absolute rock stars. CPAs would appreciate it.

Cal Wilder  32:44
So however, you've chosen to account for owner compensation, and however you've chosen to get the cash out of the business, you're going to have a tax bill to pay at the end of the year, assuming the business had some taxable profit. The nightmare scenario is the small business owner gets to April, gets the tax return from their CPA, and sees they owe a lot of money to the IRS and their state government, and they don't have any cash to pay those tax bills. That's a nightmare, right? So how do we avoid not having the cash on hand to pay tax bills?

Greg Reed  33:21
This is where proper tax planning comes into place and why you should be talking to your CPA throughout the year. So effectively, your right nightmare scenario is you've pulled out all this money from a distribution, your balance sheet or the income statement looks awesome. You're like, that's great, but I don't have this much money in my business right now. And it's essentially because you pulled it out and paid yourself and, you know, either put it in your own personal savings or went out and bought a new car or boat or something like that. And now you've got this big tax bill, and you don't have the cash to pay it. Unfortunately, this does happen. And it really is a result of not fully understanding your financial statements and not having those conversations with your CPA throughout the year. So I always say that if having a W2 and distribution breakout is part of the plan, that's great, but on a monthly basis or quarterly basis, you want to make sure that before you take that distribution, you're also factoring in how much needs to be kind of put aside for taxes. And so, for example, if you're like alright, every month, I'm going to take $12,000 in a in a salary, and we're going to take $8,000 in a distribution, then you want to make sure that part of that eight is put aside for taxes or that you have avail cash on hand to pay for taxes either quarterly, or come come tax time. So that is something that we will do with our clients throughout the year, talk with them and make sure that not only are they paying themselves a fair salary, and a fair distribution, but they're also factoring in, okay, I am going to need to put this money aside for taxes and making sure that they have that adequately calculated.

Cal Wilder  36:05
So effectively, when taking a distribution, you earmark the first X dollars toward taxes and then what's left over is net take home that you can go spend on a boat.

Greg Reed  36:18
Yea, it's not an exact science. But that's typically how they the scenario works.

Cal Wilder  36:30
Then the other way we sometimes see clients tackle this challenge is they put aside a certain percentage of the business's profit into a separate dedicated bank account. So they work with their CPA like you to figure out what their projected tax bill is going to be for the year, and then say it kind of works out that they're going to owe about 30% of the company's profit to the IRS. And so every month, every quarter, they'll take 30% of the profit and transfer it from the operating checking account to a tax savings account, hopefully earning a little bit of interest. And so they're effectively saving that money in earmarking it so it's available to pay taxes later. And maybe they pay their quarterly tax estimated tax payments out of that separate bank account, where if they, for whatever reason, don't want to make quarterly estimated tax payments, then there's gonna be accumulating that cash earning interest on it over the course of the year, and then it will be available there in March or April when they need to pay their taxes.

Greg Reed  37:38
Yeah, that's a completely different tax strategy. But essentially, yes, pulling it, putting it aside, paying it out a quarterly, or, you know, one time, you know, depending on, you know, underpayment penalties and how that all factors in. But yeah, that would be the way that ideally it comes out. And ideally, you're putting money aside every month. And then at the end of the quarter, you have that money to go ahead and make that tax payment.

Cal Wilder  38:14
Practitioners of the Profit First method, like we talked about in episode 14 with Rocky Lalvani Putting Profit First, they even go so far as to create an additional bank account dedicated to taxes separate from profit. They transfer whatever the estimated tax liability is going to be into that tax bank account and hold it in a dedicated tax bank account. You know the pros and cons, there's only so many bank accounts you want to be managing and moving cash between, but that is another approach as well to have a dedicated bank account just for taxes.

Greg Reed  38:52
Yeah it's one way to do it.

Cal Wilder  38:57
All right, Greg, so this can get complicated. So what do you see as some of the larger pitfalls or problems related to owner compensation with clients that you work with or or start engaging with as a new tax client for your practice?

Greg Reed  39:17
Yeah, so a couple of the bigger ones is that you know, I always tell especially my older clients that if you pay yourself a lower compensation, then that could negatively affect how much you get with from Social Security when you go to retire. Some clients don't care about that because they're already financially secure. But for other clients it is something that they are they need to factor in. So just be aware that if you're going to essentially like lowball the the wages, that is going to impact your Social Security, or could potentially impact your social security, in a negative way and reduce that amount. The other one is, a lot of times, owners will assume that whatever they're withholding from their owners compensation and so on their W2 is going to cover all of their taxes. That's definitely not the case, unless you are withholding it like a 70% rate. It's really just gonna cover whatever your wages are. So if you're paying yourself 60,000, and you're withholding, you just pick your standard married filing joint with one dependent or single zero or something like that, it's just basically going to withhold as if you were a regular W2 employee working for another business. So, don't assume that everything you pay in through your your payroll is going to cover all of your taxes. We have to consider the net income that we just alluded to a few minutes ago.

Cal Wilder  41:34
And if there's one single thing that a small business owner can do to keep their CPA happy when it comes to owner compensation practices, what would that be?

Greg Reed  41:44
Don't pay yourself a low amount. Don't try to convince your CPA that you only are worth $12,000 a year. Because I've had clients try to lowball me, and it doesn't create a great relationship. And it could certainly, you know, bury you in in the future if the IRS were to come in and say, that's great, but we're going to take all these distributions that you paid yourself, and we're going to basically convert them to a salary and now you owe us not only payroll taxes, but all the penalties and interest associated with it. Not necessarily a fun conversation to have.

Cal Wilder  42:34
So if I reflect back on this conversation, it seems pretty clear that the form of owner compensation is directly tied to important legal entity selection decisions and potential election decisions that are made with the IRS for how LLCs would be taxed and needs to be considered in the context of the overall individual and family income and tax picture, not just the business itself, or a single owner, right? And so I think this conversation just reinforces the importance of working with a more proactive CPA who can help put together a plan that takes all these factors into consideration, and helps you make decisions that align with what your tax and financial objectives are.

Greg Reed  43:27
Yeah, absolutely. I think that if you're just a single member LLC right now, and businesses continuing to grow, then it's probably going to make a lot of sense to bring in a professional if you don't already have one, you know, sooner than later, just so you can maximize any tax savings opportunities and avoid any pitfalls.

Cal Wilder  43:55
Greg, thank you so much for coming on the podcast again, and sharing this valuable information for the audience. If folks want to follow up with you directly, what's the best way for them to get in touch with you?

Greg Reed  44:07
So you can reach out to me via email greed@SmartBooksTax.com is probably the best way to get a hold of me. You can alovisit our website smartbooktaxs.com, and there's a link there to set up an appointment with me via my calendar link so you can set up a time that's convenient for you to chat. Those are probably the two best ways to get in contact with me. Hopefully we can help you out with any tax savings.

Cal Wilder  44:43
Thanks, Greg. Look forward to having you back again when we can find another riveting tax topic to discuss.

Greg Reed  44:50
They're all riveting, right?

Cal Wilder  44:53
Reference show notes and find other episodes on EmpoweringHealthyBusiness.com. If you would like to have a one-on-one discussion with me, or possibly engage SmartBooks to help with your business, you can reach me at Cal@EmpoweringHealthyBusiness.com or message me on LinkedIn where I am easy to find. Until next time, this is Empowering Healthy Business, the podcast for small business owners, signing off.

Forms of Owner Compensation and How They Are Taxed
W-2 Wages
Owner Distributions
Discretionary Expenses & Fringe Benefits
Reasonable W-2 Compensation for Owners of S-Corporations and Mitigating Self Employment Tax
Accounting for LLC Owner Compensation in Financial Statements and Accurately Reporting Business Profitability
Retaining Cash to Pay Taxes