You’ve finally gotten your business off the ground. You’re in a place where you can decide how much to pay yourself each month, and that stability feels good. You sat down with your accountant and decided on your reasonable owner’s compensation. You look at that number, and… your heart sinks a bit. You feel like it’s not enough.
Don’t get frustrated yet. There are ways to maximize what you’re already making by paying yourself in addition to your salary. Yes, really! You can do this using distributions and bonuses.
Your annual salary – your reasonable owner’s compensation – is payment for your day-to-day work in the business. This is essentially what it would cost your business to replace you and your role. Let’s say your reasonable owner’s compensation is $50,000, for example.
“Distribution” refers to money you can also take from the business on top of that. It’s NOT an expense to the business, but it’s also not income to you personally … so you don’t have to pay additional income taxes on it. This would be money outside of your $50k reasonable compensation, and it’s a huge benefit of being a business owner.
Meaning? If you’ve ever received a paycheck, you know that if you make $5k a month, the check will probably be around $4k after paying the payroll taxes. But a distribution will be a check for the full amount – meaning no taxes are taken out.
The catch? Your business has to have enough net income in order to support taking a distribution. The term is technically your “basis,” but we’re not going to go that deep here in this post. Be sure to work closely with your qualified tax professional to ensure you’re not taking out more in distributions than what your business has accumulated in basis for you to take (and yes, this accumulates year over year).
So if you need $5k, and the business can support you taking that money… you can through a distribution!
How a Distribution Works
To paint a clear picture, let’s look at an example of how a distribution works.
Let’s say your business made $350,000 in gross revenue for 2022. After deducting all of your expenses (advertising, contractors, employee wages, etc.), you have $150,000 in PROFIT. Your reasonable compensation is determined to be $50,000 this year - which is paid as wages via payroll expense thus bringing your taxable net income from the business to $100,000.
You’ll report $100,000 of income on your taxes which will be taxed as pass through income on a Form K-1 from the business AND $50,000 will be reported as your W-2 income.
A distribution could pull from the $100,000 “basis” you have in the business (remember we’re oversimplifying a basis calculation here). There are many risks and rewards of being a business owner… and distributions are definitely a big reward!
Another way to add to your wealth is by giving yourself a bonus. You can give yourself a bonus quarterly or annually (this is what I do with my clients) if you see the business has made plenty of money that quarter or year. This is also really great if you have a seasonal basis, do launches or any time income is not consistent throughout the year.
As a reminder, your paychecks should always be consistent. But on top of the paychecks, you can give bonuses quarterly, twice a year, or once a year (or honestly, however works best for your business). That income is still subject to payroll taxes, and you don’t give bonuses until you know the business has made enough money to sustain the bonus; but it’s another way to increase your income.
Many corporations give bonuses. Some are performance or profit based; I got a busy season bonus every year when I was still in corporate accounting after tax season was over. You can set your base salary as something your business can consistently afford, and then give yourself a bonus after a great quarter or launch.
Make Your Business Work for You
At the end of the day, we didn’t start our businesses to work harder than we did before. We started our businesses because we’re passionate and we want it to work for us.
It’s important to make sure your business isn’t running you, but that YOU are running your business. Be sure to work with a tax professional to ensure you are paying yourself a reasonable amount to make your work worth all the time, effort and stress.
Tax planning and being smart about your business finances can help you maximize what you’re bringing in. Instead of trying to make more, maximize what you’re already bringing in so you can start building wealth today.
Interested in seeing how our firm can help?
*Disclaimer: This article is not meant to be tax advice. This is not an all-inclusive list of business advice. Different rules may apply to each individual taxpayer’s specific situation. Please consult with your accountant.