Sole Proprietor
If you are a sole proprietor, you do not have to decide what salary to pay yourself. Your net income as reported on the Schedule C as part of your personal Form 1040 will have self-employment tax automatically calculated on the entire amount!
Salary Versus No Salary
Salary incurs extra business expenses. Medicare and social security tax has to be matched by the employer and can be up to almost eight percent of the wages paid. Additionally, federal and state unemployment taxes will be incurred.
Why Pay Wages
You will lose in tax court if you are an owner and operator of an s corporation and do not pay any wages to yourself. The court has consistently ruled that you must pay yourself reasonable wages indicative of the industry your business is in.
Put plainly, if you do not pay wages to yourself, the Internal Revenue Service (IRS) will flag your return. The IRS will usually claim all your net income is wages and say you owe the extra wages taxes on all of it. You are likely to dispute that amount and come up with a more reasonable wage amount. But now you are in dispute and may wind up in tax court. What is your time worth? You may have to bring knowledgeable representation with you. Let’s restate that. You may have to bring very extremely expensive knowledgeable representation with you. Now you are at a deficit on the amount of possible savings. Because in any court, nothing is slam dunk. The court may rule 100% favorably for the IRS.
W-2 Versus No W-2
If you pay yourself wages, you will be issued a W-2. This means your wages will be taxes at your personal federal tax rate. If you do not pay wages, the savings will come in the form of the extra business expenses incurred on wages explained earlier.
If you have a pass through entity, the net income without wages will still end up being taxed at your personal federal tax rate. A pass through entity is one that is not taxed, but the income passes through to the owners and is taxed as part of the owner’s federal personal tax return.
If no wages are paid and your business entity is a c corporation, the net income will be taxed at the corporate tax rate. Then when dividends are issued to you, the owner, you will pay taxes on that same income again. It's your choice to pay wage taxes now or other taxes later.
Other Considerations
Another scenario is that you are the only employee of your entity. IF you implement a retirement plan, there may be a large deduction form your wages for the yearly contribution. Let’s say you have wages of $25,000, with a $15,000 retirement deduction. You must pay social security and medicare tax on the entire $25,000. But only $10,000 will be subject to federal income tax.
You may deduct the cost of medical insurance for you and your family on a pretax basis to further reduce your personal federal taxable income. You may be the employee, but you are also the boss. Consider your hiring and compensation decisions carefully.
For more information about Forms W-2 and 1099, visit the Internal Revenue Service website. Information on the sole proprietorship business form may also be obtained here by typing "sole proprietorship" in the upper right-hand search box on the website.
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