Salary or Draw

April 13, 2006

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If your business is structured as a sole proprietorship, you will pay yourself directly through an "owner's draw" and report this through Schedule C of your individual tax return. If your business is organized as another type of "flow through" 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 more by the cash-flow characteristics of the operation than by tax law imperatives. Since you will be personally taxed on the profits of any non-C corporation business whether you draw a formal salary or not, it's a distinction without a difference.

From the owner's standpoint, the term "salary" really applies only to C corporations. (Of course, employees having no ownership interest are paid wages or a salary, regardless of the structure of the business, but here our discussion is confined to an owner's salary from a C corporation.)

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.

A key determination here is 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.

The following chart compares the marginal tax rates for the 2006 tax year for corporations, married individuals filing jointly, and single individuals.

Taxable Income (Dollars)	Corp.	Married/Joint	Individual
0-7,500	15%	10%	10%
7,501-15,100	15%	10%	15%
15,101-30,650	15%	15%	15%
30,651-50,000	15%	15%	25%
50,001-61,300	25%	15%	25%
61,301-74,200	25%	25%	25%
74,201-75,000	25%	25%	28%
75,001-100,000	34%	25%	28%
100,001-123,700	39%	25%	28%
123,701-154,800	39%	28%	28%
154,801-188,450	39%	28%	33%
188,451-335,000	39%	33%	33%
335,001-336,550	34%	33%	33%
336,551-10,000,000	34%	35%	35%
10,000,001-15,000,000	35%	35%	35%
15,000,001-18,333,333	38%	35%	35%
Over 18,333,333	35%	35%	35%

Personal service corporations. The rates listed in this table apply to most corporations. However, there's an exception for personal service corporations (PSCs). All the profits of a PSC are taxed at a flat rate of 35 percent. PSCs are defined as corporations performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, the performing arts, or consulting, where substantially all of the stock is held by employees, retired employees, or their estates.

Delayed payments. If you have an accrual basis corporation in which you own less than 50 percent of the stock, your company can deduct your compensation in one year and, as long as it's paid out to you no later than two and one-half months after the end of the company's tax year, you needn't report it as personal income until the year it was actually received. This method accelerates the deduction when the company needs to reduce profits and postpones taxation of income to you personally.

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 the wealth-building techniques which are beyond the scope of our discussion here.