Your Compensation Type Matters

Over the past two years, I've established a few retirement plans for home builders and construction-related companies. The owners run profitable companies and make lots of money, but sometimes they leave too much responsibility in the hands of their accountants and attorneys. Some owners don't know their company structure; others don't know whether they receive salary or draw. Lacking this information, they are susceptible to a financial planner who might set up a company retirement plan that's not in the owner's best interests.

Choosing a retirement plan for a company starts with an understanding of the company's corporate structure, as that determines whether an owner is compensated via salary, earned income, passive income or portfolio income. That determination dictates the type of pension plan most appropriate for the owner and the company's employees.

Retirement plans and corporate structures are complex. I established a retirement plan for one company whose owner (we later discovered) was a subcontractor to his own firm. But he was also a company officer. This is clearly a no-no with the Internal Revenue Service. (This was not of his own doing. Professionals with obviously different interpretations of the tax code had done the company's tax returns as well as its initial incorporation.)

Then there was the company owner who had a multitude of companies with earnings from each. But all the companies were limited liability companies, which meant he was not a salaried employee on payroll, but an owner with earned income. He knew ahead of time that the SIMPLE individual retirement account he established for his employees was done solely for their benefit, as he was prohibited from participating in that type of plan. (SIMPLE IRAs require salaried income; this individual received earned income only.)

How about the company owner who told me he took all his salary as draw and allegedly paid no payroll taxes? His Social Security statement showed considerable earned income, and his old accountant said he could contribute anyway to a retirement plan in which contributions were predicated on salary. But his new accountant said maybe not. Comical? Not quite. This is serious business.

It is incumbent upon company owners to understand their corporate structure and then realize how they are compensated. Many owners don't realize that not earning a salary doesn’t mean they're not paying payroll taxes; they're just not seeing those deductions in their regular pay stubs. Some owners of S corporations, for example, might even be taking all their income in the form of a distribution with no commensurate salary. They risk having some of their distributed income re-characterized as salary by the IRS.

Bottom line: Educate yourself about accounting and tax basics to ensure that the tax treatment of your income is appropriate. When applicable, take a regular salary. Withhold or pay quarterly taxes. While reducing salary or earned income to the bare minimum might seem attractive in terms of the payroll taxes saved, there is a price to pay later. Remember, salary reduction retirement plans require salary in order for an employee-owner to participate.

When it comes to setting aside funds for retirement, pretax dollars are a whole lot better than after-tax contributions. And the more, the better.