Business Income: Begin With The End In Mind

BY: Alex Pudlo


As any business owner can attest, there are myriad financial considerations that must be taken into account in deciding how to run the business. They can choose (to some extent) how much to pay themselves in terms of a salary, a bonus, and, if there is money left over, a distribution or dividend from the enterprise’s profits. A qualified tax advisor is very helpful in making those year-to-year decisions.

It’s important to be mindful, though, of the consequences that these decisions can have over time. Let’s take a look at a quick example:

Owner A (Sally) pays herself a low salary and distributes income to herself through dividend distributions at a lower combined tax rate than through the inverse situation, which is how Owner B (Doug) chooses to pay himself. (Assume that their businesses are financially identical.)

Forty years down the road, both owners sell their businesses and retire. Sally has 40 years of relatively low salary for the Social Security Administration to consider when calculating her Social Security payments, and she also has received a lower absolute company match on her 401(k) contributions over the years. However, she has saved in other dedicated, non-tax-advantaged investment accounts.

Doug has a higher 401(k) balance and higher Social Security payments, but less in “non-qualified” (or less tax-advantaged) investment accounts, as he has paid higher taxes throughout the last 40 years. The tradeoff is that he will spend his remaining years paying less in taxes than will Sally.

The scenario above is over-simplistic; there are, of course, a number of factors – breakeven points, changes in tax rates and taxation policies, personal and emotional preferences – at play in the decision-making processes of both Sally and Doug. The point of this article is not to suggest a given path, but rather to highlight some of the most important points to consider.

  • Current tax considerations: Most people think of this first. Federal income taxes are generally higher (up to 39.6%) than taxes on qualified distributions from business earnings (i.e., dividends). So there is a “right now” advantage to decreasing salary in favor of qualified dividends taxed at 15%-23.8%.
  • Future tax considerations: For many business owners, the end goal is to ultimately sell the company. For others, passing it to a child or other relative might be in the cards. Depending on the option that you choose, there could be a huge difference in how you plan your income. If succession is in the offing, your basis in the business may not be an important consideration for tax planning. For those who do plan to sell, how much do you want to pay in capital gains taxes? You have some control over that by planning distributions carefully, so that the gap between your basis and your sale price is appropriate for your overall plans.
  • Company retirement plan considerations: You will also be deciding how to save for retirement. You probably have a retirement plan for your employees, which includes you, and there is likely a match on employee contributions. How much do you want to receive as a part of that match? If you only pay yourself a minimal salary, your match will also be minimal. That may be good (to prevent the plan from being “top heavy”) or bad. It simply depends on your unique plan.

This may also be your best opportunity to save money in a Roth style account: pay taxes now and never again on those savings. Roth accounts may not make financial sense for some people. They can be used as an “insurance policy,” so to speak, insuring against significantly higher tax rates in the future, due to either success of the business or government tax-policy changes. For that reason, some people choose to make Roth 401(k) contributions, even if doing so may result in an lower overall net worth at retirement, with the benefit of the peace of mind that they have hedged against upward future tax-rate changes.

Again, this list is not comprehensive, and there are many additional items to weigh. The object is to help you, as a business owner, to step outside your day-to-day and even year-to-year planning, and instead begin with the end in mind.

The calculations for these decisions are extremely complex, and they all affect each other. You can’t change your salary without affecting your 401(k), Social Security, and, likely, the final capital gains taxes you pay on the sale of your business, as well as many other consequences that are too specific to get into here.

Ultimately, the best thing you can do is find a competent professional who can model out (literally) dozens of different scenarios and synthesize them for you in a brief and digestible format, so that you have a framework for making your decisions.
Author:

Alex Pudlo

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