Does it feel like most of your hard-earned money goes out the door to taxes after running your payroll for the period?
In this blog article, I’m going to share with you how my clients who are successful business owners have managed to optimize their payroll and save on taxes.
Payroll is the second-largest expense in a successful business. This is because labor costs are associated with payroll taxes. Many business owners today have the option to reduce payroll taxes by offering incentives to themselves, family members who are employed in the business, and other employees.
Entity structure is important to optimize payroll tax savings. You want to make sure that you have a legal entity in place that is active. In our professional opinion, the legal entity preferred is either the limited liability company or corporation.
As a small business owner, if you already have an active legal entity, as provided in the previous paragraph, it would be best to convert to an S-Corporation to reduce your taxes before optimizing your payroll taxes. Below is a case study of a trades company that was paying both self-employment taxes and payroll taxes without any tax incentives.
Case Study #1 – Conversion to an S-Corporation and Reasonable Compensation
A proud family-owned construction partnership run by two brothers, Jack and Jim, found themselves in a situation where they were overpaying in Social Security and Medicare taxes. The siblings were unaware of the rules regarding their entity structure and erroneously paid themselves as employees of their organization. Under common law, single or multi-member limited liability company owners are not allowed to pay themselves as employees; the law does not recognize owners of these types of structures as employees. Therefore, as a structured limited liability company, the IRS requires that self-employment taxes be paid when filing the income tax return.
Jack and Jim’s partnership reported a net profit of $230,000, which was split 50/50 along with reportable W-2 wages paid at $100,000 each, effectively paying $30,600 in payroll taxes. Each sibling was to report $115,000 in taxable income, which created additional taxes of $17,595. To optimize their tax savings, the siblings made a conversion to a small business corporation, changing their status as members to shareholders who can now take tax-free distributions at the entity level and remove the additional tax of $17,595 in self-employment taxes.
What about reasonable compensation? Reasonable compensation is based on how much equity the owners intend to take out for personal living expenses. This can be budgeted and paid out over the course of a year. If Jack and Jim took out $100,000 each for compensation, then under the S-Corporation rules, reasonable compensation could have been $50,000 each, with tax-free distributions of $50,000 each. Therefore, the $30,600 of payroll taxes paid could have been reduced by $15,300—used for resources for the company or additional savings for the owner/employee.
Optimize Payroll Taxes Through Health Reimbursement Arrangements (HRAs)
An HRA allows business owners to reimburse their employees (including themselves and family members) for medical expenses such as health insurance premiums, medical treatments, and prescriptions, reducing taxable income. By setting up a qualified small employer HRA (QSEHRA) or an individual coverage HRA (ICHRA), the reimbursements are deductible as business expenses, reducing payroll taxes.
For example, if a small business owner offers an HRA to themselves and their spouse, they can reimburse their personal health insurance premiums through the business and deduct those payments, lowering their taxable income and saving on payroll taxes.
Optimize Payroll Taxes by Hiring Family Members
Business owners can optimize their payroll tax savings by hiring family members, including children, spouses, or parents. In some cases, hiring your child can offer payroll tax exemptions. For example, if your business is a sole proprietorship or a partnership where both partners are parents of the child, wages paid to children under 18 are exempt from Social Security and Medicare taxes. Additionally, paying a salary to a spouse allows them to qualify for benefits like retirement plan contributions and health insurance, while the business benefits from the corresponding tax deductions.
By paying family members, not only can you reduce taxable income, but you can also take advantage of tax deductions associated with their compensation and benefits.
Case Study #2 – Retirement
Joey and Elaine are husband and wife. Elaine owns and operates a medical practice with the help of her husband Joey and a few other staff members. Joey handles all the finances of the medical practice and is a stickler about paying taxes on time. One day, they discovered that rather than contributing to a Roth IRA annually, they could double down on their retirement by contributing up to $23,000 or $30,500 for participants 50 years or older using a 401(k) qualified plan. Paying into a Roth IRA is great; however, you are limited to annual contributions of $7,000 or $8,000 if 50 years and older. A Roth IRA grows tax-free; however, you are further limited to the amount that you can contribute if your income falls within the phase-out income ranges of $146,000 to $161,000 if filing single, head of household, or married filing separately, and $230,000 – $240,000 if filing married filing jointly.
With Joey and Elaine participating in a 401(k) plan owned by Elaine’s medical practice, both the owner, spouse, and employees can participate by opting in. Once Elaine implemented the 401(k) plan for her medical practice, she was able to pay herself and her spouse and allocate the max deferral contributions to each 401(k) without having to pay any FICA, federal, or state withholdings on that portion of their W-2 wages.
Conclusion
Optimizing payroll tax savings is a key strategy for business owners looking to improve their bottom line. By carefully selecting the right entity structure, offering retirement plans, utilizing health reimbursement arrangements, and hiring family members, you can significantly reduce payroll taxes and reinvest those savings into growing your business. Each business is unique, so it’s essential to consult with a tax professional to implement the best strategies for your specific situation. Start taking steps today to optimize your payroll taxes and keep more of your hard-earned money working for you!
Book a free discovery call to learn how this can work for you!
