3 reasons to increase your salary as an S corporation owner

Every S corporation owner must pay herself reasonable compensation for the work she performs in her business. That means paying yourself a salary, subject to payroll tax and income tax withholding.

As an S corporation owner, you typically want to minimize your salary to reduce your payroll tax burden; however, there are instances when increasing your salary may provide a greater advantage or a long-term benefit:

1. Retirement contributions
2. Child and dependent care credit
3. Health insurance premiums

Retirement contributions

Your salary determines the maximum amount you can contribute to a small business tax-advantaged retirement account, such as simplified employee pension plan (SEP) or a 401(k) plan.

The higher your salary, the more you can contribute to these plans (up to a generous annual maximum contribution):

• The SEP limit is 25 percent of your salary. For every extra $1,000 you want to contribute to your SEP, you must pay yourself an additional $4,000 in salary.
• The 401(k) includes two parts: first, the employee contribution (or deferred salary), which is subject to payroll tax (but not income tax), and is limited to an inflation-adjusted maximum; and second, the employer contribution, which—like the SEP—is limited to 25 percent of your salary.

Child and dependent care credit

If you paid someone to care for your child (or other dependent) while you worked (or looked for work), you can claim a credit based on the number of children (dependents), the amounts paid per child (dependent), and your earned income.

That last part—earned income—is the key: Passthrough income from your S corporation does not qualify as earned income; however, your salary does.

The credit calculation takes the smaller of your dependent care expenses (up to a limit) and your earned income, so you want to make sure your salary at least matches that limit.

Health insurance premiums

Self-employed people may deduct their out-of-pocket premium payments. (This helps achieve parity with employees, who often receive tax-free premium payments from their employers as part of their total compensation.)

For sole proprietorships and partnerships, this deduction can appear directly on the individual tax return.

S corporation owners are not considered self-employed for the purposes of this deduction. To deduct the costs, the S corporation must pay the premiums and include the amounts in the owner/employee’s salary; however, the amount is not subject to payroll tax, although it is subject to income tax withholding. The additional salary is then deducted on the owner’s individual tax return.