S-Corporations are great for successful service-based businesses, like agencies or consultant companies. If you’re making 7+ figures, it’s a popular and beneficial overall entity structure.
However, with just about anything, there are concerns about the ins-and-outs of managing margins and cash flow. When it comes to cash management strategies for professional services, one of the first questions we often hear is, “How much money should I take out of the business?”
How much money should I take out of my business?
It’s a great question.
Agency owners are often afraid of taking out money (for themselves)—for two reasons:
- The assumption it negatively affects their tax filing (aka, they’ll pay more in taxes)
- A potential to take too much out of the business, not leaving enough cash reserves in the event of an emergency
This article is to alleviate these fears, while providing a five-step system for taking a salary from your hard-earned money.
Note: This process fits best for an S-Corp, particularly for a service-based business, like digital agencies, consultants, etc. These tips do have crossover for other organizations structured as an S-Corp, but it’s important to bear in mind the target example.
5 Step System to Take a Salary from an S-Corporation
1. Pay yourself a reasonable salary (as required by the IRS)
The term reasonable sounds ambiguous, doesn’t it? Even the IRS guidance says, “There are no specific guidelines for reasonable compensation in the Code or the Regulations.”
However, courts have ruled, creating a bit more boundaries on what a reasonable compensation is, for your business. One of the best ways to consider the amount to pay yourself is imagining having to hire your replacement.
The reason? “Reasonable” can mean the salary you’d pay someone if you had to replace yourself, but ask your tax accountant for guidance here.
Reaching back to the IRS guidance, it mentions considering things like:
- Time requirements
- Salaries you pay to those who don’t have shares in the company
- Industry comparisons (e.g. average salary of an agency CEO)
- Health and other benefits
From your tax burden’s perspective, a lower salary is often better, in terms of paying payroll taxes. But that is why the IRS requires you to consider what’s reasonable. If you’re allowed to pay yourself meager wages, it’s essentially skirting around those payroll taxes, to the IRS.
Key point: There’s a sweet spot between saving on payroll taxes and keeping the IRS off your back. Handle the subject with care and get some sound advice from an tax accountant.
2. Tweak for businesses with substantial cash flow
Once you have that “reasonable” salary number, it’s possible (and a good idea if you have significant profits each month after paying your salary) for 100% of your wages to go toward income taxes and your 401K.
Example: When you set up your payroll withholdings, have 100% allocated between:
- State Income Taxes
- Federal Income Taxes
If the math is right, your net take-home pay will then be close to, or right at $0. But—you’ll still get a W-2 for your salary which keeps the IRS happy.
Key point: Use your wages to go toward payroll withholdings, and potentially avoid the hassle of making quarterly tax payments.
3. Pay yourself a monthly distribution
So you paid all your wages toward taxes and 401K, but you gotta live, right?
Here’s a great rule of thumb for covering your living expenses (and lifestyle) while keeping your business running smoothly.
- First, keep 8-10% of your annual gross revenue (not including pass through costs) in the bank, as a cash reserve.
- Next, each month take out a cash distribution for the amount over that percentage.
- Use this monthly payment to live your life and pay your bills.
Example: You expect (based on good data) to do $1,200,000 in gross revenue, annually. You decide to keep roughly $100,000 in your bank accounts in cash reserves (technically, 8-10% is $96K-$120K).. At the end of the month, let’s say you have $130,000 in the bank. You can take out $30,000 as a distribution.
Make sure to have a firm number you reevaluate regularly. Don’t be tempted to dig into your cash reserve. Set a number and stick to it.
Note: YOU DO NOT GET TAXED ON YOUR DISTRIBUTIONS. You are taxed on your NET PROFIT. Since you’re already taxed on your net income, you are not taxed on your distributions. (Your net income is reported on a form K-1.)
What does that mean?
Key point: Don’t be shy about taking out the money due to tax fears. You either already paid them, or you will, via payroll withholdings or quarterly estimates. It doesn’t change your taxable income.
4. Distribute cash for quarterly tax vouchers
Paying more in taxes than your wage withholding can cover? If so, it likely means your tax accountant has given you quarterly estimated tax vouchers. To be clear, vouchers are only used if tax payments are BEYOND what you’re paying through payroll withholding.
If this is your situation, and it may be, you can distribute cash from the business to yourself each quarter for these tax payments.
Key point: If you use all of your salary to go toward taxes and you still owe estimated taxes, make a distribution to yourself and then pay your quarterly estimates from your personal bank account.
5. Work with your tax accountant at the right time (June and November)
Most of these informational articles mention working with an accountant, and that is wonderful advice. But there’s nuanced timing to when you want to snag a time with your firm. The best times are around June and November.
These months give you plenty of time before either tax or extension season, but enough data for an accountant to see if you’re on track. Plus, they’ll have ample time to answer questions and see any potential surprises—before they hit you out of nowhere. They will look at your year-to-date tax withholdings through payroll and your quarterly estimated payments and make sure you’re on track.
5 Step System to Take a Salary from an S-Corporation
This is the 5-step framework for setting up a cash operating system for your S-Corp. If you’re ready to work with a partner who can help you manage your cash and grow your agency, get in touch with us today!