The decisions you make about how you pay yourself, your family, and your employees can significantly impact your tax situation and financial future. For business owners, understanding the various compensation strategies available can potentially help minimize tax burdens while seeking to build wealth for the future.
This article explores historically effective compensation strategies focusing on key areas: optimizing W-2 and K-1 distributions, employing family members, leveraging retirement plans, and utilizing charitable giving approaches. It’s informed by a recorded conversation we had with one of our CPA referral partners. You can watch the video below.
Table of Contents:
One of the first decisions business owners must make is determining the balance between W-2 salary and K-1 distributions. This is particularly important for S-Corporation owners who have flexibility in how they pay themselves.
W-2 compensation is subject to payroll taxes (approximately 15.3%) plus federal income tax, while K-1 distributions are only subject to federal income tax. This creates an opportunity to minimize your overall tax burden by finding the optimal mix between these two compensation methods.
However, the IRS requires business owners to pay themselves a "reasonable compensation" through W-2 wages before taking K-1 distributions. What constitutes "reasonable" varies by:
The IRS is particularly attentive to situations where:
One CPA shared an example of a business owner who paid himself only $40,000 in W-2 wages while taking $2-3 million in distributions. When audited, the owner successfully defended this arrangement by demonstrating he had hired a full-time CEO and CFO to run the business, while he spent most of his time away from active management.
When determining your compensation structure:
Employing family members can be an effective tax planning strategy when implemented correctly. However, proper documentation and legitimate business purposes are essential.
Employing a spouse can provide several benefits:
The key requirement is that your spouse must perform actual, valuable work for the business. Document their role, responsibilities, and hours worked to substantiate their employment in case of an audit.
Paying children for legitimate work in your business can be a powerful tax planning tool. For 2025, the standard deduction for a dependent is $15,000, meaning children can earn up to this amount without owing federal income tax.
Key considerations for employing children include:
One important note: Be mindful of the $15,000 threshold if your child has other employment. If they earn income from another job, you'll need to adjust their compensation from your business to stay under the filing threshold.
Retirement plans offer potentially significant tax advantages for business owners, particularly those in higher tax brackets. The basic principle is to leverage W-2 income in an effort to maximize retirement plan contributions.
The tax arbitrage opportunity here is clear: By paying yourself enough W-2 income to maximize retirement contributions, you may pay more in payroll taxes (15.3%) but can achieve tax deferral at your highest marginal rate (potentially 37%), creating a potentially significant net benefit.
When you employ family members, they can also participate in retirement plans. This creates additional tax-advantaged savings opportunities for the family unit. For example, a spouse with even modest W-2 compensation can defer a significant portion into retirement accounts.
For high-income business owners looking to maximize tax-deferred savings, defined benefit pension plans offer a powerful strategy beyond traditional qualified plans.
Unlike 401(k)s with fixed annual contribution limits, defined benefit plans calculate contributions based on:
These plans can allow contributions of $200,000-$300,000+ annually in some cases, creating significant tax deductions.
Defined benefit plans typically work best for:
These plans do require administrative overhead and actuarial calculations, but the tax benefits can far outweigh these costs for the right business owner.
While S-Corporations and LLCs are more common small business structures, C-Corporations offer distinct planning opportunities in certain situations.
One significant advantage of C-Corporations is the Qualified Small Business Stock (QSBS) exclusion under Section 1202 of the tax code. This provision allows:
This can be particularly valuable for startup founders and early employees who expect significant appreciation in company stock.
C-Corporations face the challenge of double taxation - once at the corporate level (21% rate) and again when profits are distributed to shareholders. Strategies to address this include:
For charitably inclined business owners, integrating giving strategies with compensation planning can potentially yield significant tax benefits.
| Type of Contribution | AGI Limit |
| Cash donations to public charities | 60% |
| Appreciated assets (e.g., stocks) held > 1 year | 30% |
| Contributions to certain private foundations | 30% |
Rather than viewing these strategies as separate tactics, consider how they potentially work together:
By taking a comprehensive approach to compensation planning, business owners have the opportunity to significantly reduce their tax burden while building wealth for themselves and their families.
Tax-smart compensation planning requires attention to detail and a long-term perspective. Working with qualified advisors who understand both the tax implications and the financial planning aspects of these strategies is essential as you seek optimal results.
Remember that while tax minimization is important, it should be balanced with your broader financial goals, including retirement readiness, business growth, and wealth transfer objectives.
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This article is for informational purposes only and should not be construed as legal or tax advice. Please consult with qualified professionals regarding your specific situation.
Instrumental Wealth is an investment adviser in Tampa, Florida. Instrumental Wealth is registered with the Securities and Exchange Commission (SEC). Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. A copy of Instrumental Wealth's current written disclosure brochure is available through the SEC's website.
Not an offer: This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has knowledge and experience to understand and make an evaluation of the information, the risks associated therewith, and any related legal, tax, or other material considerations. To the extent that the reader has any questions regarding the applicability of this information to their specific situation, they are encouraged to contact David Silver or consult with the professional advisor of their choosing.