Salary or Draw

If your business is structured 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.

The term "salary" 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.

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 may 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. Note that recent tax changes may make a C corporation more attractive for some taxpayers.

Personal service corporations. Personal service corporations (PSCs) are taxed differently that other corporations. 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.