Personal Portfolio

When and how to give yourself that extra paycheck

It's almost the end of the year. Have you paid yourself a bonus? Often, time- and cash-strapped business owners don't think about their bonuses until the last minute. Unfortunately, that approach can leave you paying yourself too little or owing too much to the tax man. With planning, you can increase your self-compensation without hurting your business. But because owners' bonuses are fraught with tricky tax issues, keep in mind "The Tax Basics of Bonuses" (below), as well as the following guidelines:

BE FLEXIBLE. Most entrepreneurial ventures go through periods when they can support owner bonuses and periods when they simply can't. It's best not to become too accustomed to either phase. As CEO of Giordano Art Ltd., an art-licensing company based in Little Neck, N.Y., George Valentino makes bonus decisions for himself and his partner each year. "Some years, those bonuses have been very attractive," he confides, although the partners skipped them entirely during the early years. Recently, the company cut back on bonuses again, but not because of a cash-flow crunch. The partners' children have entered the business, bringing big growth plans that require investment.

DON'T PROCRASTINATE. Forget the tradition of annual bonuses. There's also a lot to be said for smaller, more frequent financial boosts. Richard Colombik, a lawyer and certified public accountant based in Schaumburg, Ill., is convinced that the only hope most entrepreneurs have of paying themselves adequate bonuses is to consider the issue each month. "What I've seen, again and again, is the business owner who says, 'I'll pay myself a bonus if there's anything left at the end of the year," observes Colombik. "Then, if the company has extra cash, the owner replaces some office furniture or buys a new computer." Colombik's suggestion: Each month, pay all expenses and set aside a reserve to deal with next month's bills. Then give yourself a bonus. (If yours is an S corporation, read "The Tax Basics of Bonuses" before trying this strategy.)

STICK TO CASH ON HAND. Say you're counting on collecting some large accounts receivable in January. What if you boost your corporate-credit-card charges to pay yourself a bonus in December and delay paying your bills until next year? Don't try it. "That's one way to wind up in trouble with the IRS," warns Michael Cascio, an accountant with Ramusevic & Cascio, a CPA firm in Elmhurst, N.Y. "If you paid yourself a bonus, and the funds weren't readily available in a bank account or other liquid assets, the IRS could decide it was a sham transaction." The result? "You could wind up paying tax penalties and facing some unpleasant business consequences as well," he notes.

The Tax Basics of Bonuses

When it comes to bonuses for business owners, tax issues can get complicated. Here are some considerations for the owners of S and C corporations. (If your business is a partnership or a limited-liability company, consult your accountant for the tax implications of bonuses.)

THE BASICS Whether your company is an S or a C corporation, all bonuses are treated as wages. On any bonus you pay yourself, you'll be expected to pay a 1.45% Medicare tax. You'll also pay a 6.2% Social Security tax if you haven't already received the maximum Social Security wages of $62,700 for 1996. Finally, add state and federal income taxes.

THE BOTTOM LINE These taxes might look pretty hefty, especially if you haven't already crossed that $62,700 Social Security limit. That's why some people try other self-compensation approaches instead, such as carefully structured retirement plans.

THE BASICS If you treat your payment as a profit distribution rather than a bonus, you can skip Social Security and Medicare taxes. But you'll face different tax bites. With C corporations, a profit distribution faces double taxation, first as a corporate dividend and then as personal income. Once you add in state as well as federal taxes, you might be paying 55% or 60% of that C corporation profit distribution in taxes. In contrast, distributions from an S corporation are not subject to federal taxes at the corporate level.

THE BOTTOM LINE Profit distributions generally make better sense than bonuses for owners of S corporations. Bonuses usually work best at C corporations, especially for owners who have crossed the Social Security wage limit.

THE BASICS Meanwhile, bonus strategies can get risky when company owners try to minimize taxes while maximizing other benefits. Say you own an S corporation and want to give yourself bonuslike compensation throughout the year but want to be able to call it a profit distribution to minimize taxes. "What some people might do is have their companies lend them cash each month--based on excess funds--and distribute enough profits at the end of the year to wipe out the loans," says CPA Richard Colombik. "They'll claim they don't owe FICA taxes because the end-of-the-year payment was a profit distribution."

THE BOTTOM LINE If you're trying a risky compensation strategy like that one, Colombik recommends that you set up safeguards for yourself with copious corporate minutes that document your salary and profit-distribution plans for the coming year--even if you're the only member of the board. In general, consult your accountant or your tax lawyer before making any bonus or dividend payment to yourself. There are numerous tax risks, including IRS penalties tied to excessive owner compensation.