One of the first things I tried to figure out when I started my own small consulting business was how to pay myself. Well, obviously, find clients and collect on accounts receivable. But exactly how to record the exchange of those collected revenues into my personal financial universe was a bit of a mystery to me.

Common sense dictated (at least, I thought it dictated) that I work out a reasonable personal budget, create “paycheck” transfer from my business account into my personal account, and then move any additional company monies into personal investments, or an occasional bender at an online DVD store.

Made sense to me. Then I talked to my accountant about taxes, specifically, self-employment taxes, the bane of everyone who has ever tried to go into business for themselves.

Turns out that by putting myself on a formal, taxable salary from my company, my firm can earn a new corporate deduction and I can protect a sizable chunk of my earnings from the government’s penalty on personal enterprise. And it’s legal—so long as the IRS and I agree on the definition of a “reasonable” salary.

Get incorporated
First, to take advantage of the salary structure I’ll discuss here, you need to legally establish your business and receive payments to a federal employer tax ID, not your Social Security number. You’ll also need to file taxes as a Small Business Corporation, commonly called an S Corp.

If you haven’t already incorporated, you should do so. If nothing else, incorporating your business creates a shield of liability protection for your personal assets, in case something goes wrong and you find yourself facing legal claims from a dissatisfied customer. Incorporation offers a wide range of additional tax benefits, depending on what type of business you operate. And it’s relatively cheap, depending on where you live—it certainly won’t run you much more than the latest PDA.

Self-employment taxes: Your company was better to you than you thought
For those of you who don’t know already, when you go to work for yourself, you immediately begin to pay about 8 percent more in federal income taxes than you did when you worked for a company. That’s because your firm contributes half of the taxes you pay for Social Security and Medicare, commonly called the Federal Insurance Contributions Act (FICA), to the tune of 7.5 percent of your taxable income. Individual employees match that 7.5 percent on their own personal taxes.

When you’re self-employed, you pay both halves of that amount—plus .3 percent, for some irritating reason—in the form of a 15.3 percent self-employment tax. For higher incomes, the bulk of the self-employment tax that goes to support Social Security caps out, but you always pay the 2.9 percent portion for Medicare, no matter how much you earn. You can see what a rude awakening this tax is for many folks who jump ship from the corporate world.

Go back on the payroll
A partial solution to this problem is to simply become an employee of your own company, and allow your corporation to pay half the FICA due on your salary. Sure, it’s still your money, but FICA payments made by a corporation are actually deductible as a business expense.

Better still, monies that you take as corporate distributions as an owner of your company are not subject to FICA or the self-employment tax—only personal income tax. (Ownership does have its advantages.)

And since small business corporate structures—both S Corps and Limited Liability Corporations (LLCs)—are never taxed as independent entities, you don’t have to pay corporate taxes on those monies, either—just personal income tax.

I’m guessing this may be a bit confusing (It was to me), so with the help of my accountant, I’ve mapped out a couple of scenarios that reflect this taxation approach (see Figure A).

Figure A
Taxes under pass-through taxation and salaried taxation

Let’s look at the first scenario, in which a company rakes in taxable earnings of $100,000. If all $100,000 is passed directly to the taxpayer without a salary accounting structure, $84,900 of those monies is subject to the 12.4 percent chunk of the self-employment tax devoted to Social Security ($84,900 is the tax year 2002 cap for this tax). All $100,000 is subject to personal income tax, as well as the uncapped 2.9 percent Medicare tax. The total: $43,427 in federal taxes.

By comparison, this taxpayer can save about $7,000 in federal taxes by paying herself a $50,000 salary. The main benefit is that only the $50,000 salary is subject to FICA taxes, both from the employee and company, eliminating that assessment on $34,900 that would have fallen under the self-employment tax Social Security cap. As an added bonus, the company earns a $3,750 deduction for the FICA it pays, bringing the total income to be taxed down to $96,250.

Obviously, the sweet spot for savings is with earnings above your designated salary and below the automatic $84,900 cutoff for the Social Security tax. However, this approach still can make sense for companies with smaller net earnings, as you can see in the second scenario. A business owner earning $50,000 and putting himself on a $35,000 salary can save more than $3,000 in federal taxes.

So what’s the catch?
At first blush, you might think the answer to all your self-employment tax woes might be to simply put yourself on a $1 salary and let somebody else worry about your Social Security benefits. The IRS isn’t quite that gullible, of course; the law states that you must pay yourself a “reasonable” salary for your own work. Unfortunately, there are no hard-and-fast guidelines on what constitutes a “reasonable” salary; ultimately, that’s a determination for you, your accountant, and—in the worst case—an IRS auditor.

“Tough thing is, you’re working with the IRS,” said Rick Oster, executive vice president of Business Filings Inc., a Madison, WI-based firmed that handles incorporation paperwork for start-up businesses.

The valid commonsense standard for determining a reasonable salary boils down to how much you would pay somebody to do the same work you’re doing yourself. Any company would want to reserve a portion of its revenues as margin over its payroll and expenses; within reason, that’s the money you can take as corporate disbursements.

“If you are bringing in $100,000 a year and you are creating all the receivables yourself, then paying yourself $40,000 is probably not going to work,” Oster said. “Maybe $65,000—there’s just no hard-and-fast rule.”

My own accountant threw out a ballpark figure of 50 percent of your company’s earnings as a reasonable salary standard. Of course, that figure is up for debate. But the IRS does look for unreasonably low salaries as an audit red flag, said Steve Hopfenmuller, an accounting consultant and president of Small Business Taxes & Management, an online newsletter.

Hopfenmuller had a client, a dentist, who was paying himself a $15,000 salary. On further review, the IRS bumped that figure to $50,000, accompanied by a hefty bill for outstanding self-employment taxes.

So, obviously, it pays to go ahead and pay up.

Are you a personal services corporation?
Another tax law hurdle that may stand between you and self-employment tax savings is the possibility that the IRS might consider your company a “personal services corporation.” This distinction was created primarily to prevent professionals from creating corporations as a way to dodge higher personal income tax rates, said Bob Meyer, who works with the IRS’s educational outreach program in San Jose, CA.

Meyer said that since corporate tax rates have jumped in recent years, the “personal services” issue is not such a big deal anymore. But certainly many IT consultants could arguably fall under this distinction, which would eliminate their companies from eligibility from the salary structure I’ve described here.

In short, if your company has no tangible product, then it’s a “personal services” corporation, Meyer said. Again, the definition of a “tangible product” remains somewhat nebulous; if you write and maintain a custom application for a client, that code may well qualify as a product. If all you do is advise your clients on which technologies to purchase, you may be in a gray area.

My own accountant said the personal services distinction is reserved almost exclusively for dentists, lawyers, and other business owners whose titles directly reflect their vocation. That’s still a little dicey; most networking experts include MCSE or some other certification on their business cards. I’d discuss this issue with your accountant, and perhaps even the local IRS office, if you can’t make the call cleanly.

So how can you set this up?
The steps for establishing a salary for yourself are fairly simple:

  1. Incorporate your business.
  2. Establish S Corp filing status.
  3. Set up the salary on your personal accounting software.

If you have created your business as an LLC, as I have, the only step here that may be a little complicated is the S Corp filing status. In this situation, you can still elect to take this approach by filing two federal forms—Form 8832, which states that you want to be treated as a corporation and not a partnership (the default for an LLC), and Form 2553, which elects for status as an S Corp. These forms need to be filed early after incorporation, or near the start of the tax year.

Of course, if you haven’t already incorporated your business, self-employment taxes may be a compelling reason for setting yourself up as an S Corp from the start. But taxes are complicated, to say the least, and each business’s situation is different.

LLCs offer tax advantages if your company will own property, but they’re also subject to fees in some states, including California and Florida, which more or less negates the “tax-free” benefit of small business structures. Despite the bad rap LLCs have picked up during the last few years, Oster said about 60 percent of Business Filings Inc.’s requests for incorporation are for LLCs, so they must be doing something right.

Gather up your plans for the next two or three years and find a professional accountant—if you don’t have one already—to determine the best organization for your business.

And if you find out why we have to pay an extra .3 percent for being self-employed, let me know.