Mason Stern, CPA
Three Factors Dentists Must Consider When Setting Their Salary
When you own your own practice, setting your salary seems like a no-brainer. Pay your bills, pay your taxes, pay your staff, and what’s left goes home with you. If only it were that simple.
It turns out there’s a lot more that goes into determining an owner’s salary than most dentists realize. If you are incorporated, you have to decide how much to take as a W-2 wage. You need to maintain a consistent personal cash flow even if the practice’s cash flow is tight. The amount you take home even affects your retirement planning. Then you must consider that tax rates can also vary based on if you pay yourself in W-2 wages or some other type of distribution. Determining your salary can be complicated, especially when you think about the tax implications that it can have on the actual take-home amount. When meeting with clients, I typically review three factors with the practice owner before determining their salary.
1. There Are Different Ways to Pay Yourself
There is no universal percentage an owner should pay himself or herself. It’s an extremely personal number typically composed of a combination of W-2 wages and distributions from the business. You want to find the right balance between personal and business cash flow. Then you also need to factor in lifestyle expectations and retirement ambitions.
Taking distributions can save you as much as 12.5% on employment taxes.
Many times, W-2 wages are seen as a doctor’s means to get money home. While this is one way the doctor can get money from the practice, there are other ways to consider. Your W-2 wages must pay Social Security (12.4%) and Medicare tax (2.9%). Withholding from wages is also the most common way to pay your federal and state income taxes, as opposed to quarterly payments. Lastly, if you have a retirement plan that allows for salary deferrals like a 401(k) plan or a SIMPLE IRA (Savings Incentive Match Plan for Employees Individual Retirement Account), these must be withheld through payroll.
In addition to wages, you may be able to take distributions from the practice. This is not run through W-2 wages and therefore not subject to the Social Security and Medicare tax. Taking distributions can save you as much as 12.5% on employment taxes. Please note, some tax situations can arise that preclude a shareholder from taking a distribution. As such, you need an advisor to help you with this balance.
2. Minimize Taxes and Maximize Retirement Contributions
In 2018, the IRS annual compensation limit for anyone who wants to maximize their personal 401(k) deferral and employer contribution is $275,000. Considering that every dollar you pay yourself through payroll is subject to payroll taxes, in most cases it doesn’t make sense to pay yourself one penny more than $275,000 in W-2 wages if you are running a retirement plan.
After maximizing 401(k) salary deferrals and withholdings for taxes on a $275,000 salary, some of our clients need additional income to maintain their lifestyle. To supplement, take the rest of what you need as distributions from the business. Depending on your business structure, your additional take-home pay will be taxed as ordinary flow-through or dividend income not subject to payroll taxes.
If you are not running a retirement plan, you do not need to hit the $275,000 limit for pension purposes. You can lower your wages and save employment taxes. You do need to be aware that lowering to an unreasonable level for your position/production could be an audit trigger. Consider industry averages for associate doctors with your same productivity levels. If you set a lower salary and need more income at home, you may also be able to take distributions to supplement.
3. Salary Dictated by Entity Type
Another complicating factor in deciding your salary can be the entity by which you operate your practice for tax purposes. You may read through the advantages of running your salary at a more optimal level but feel trapped because you are operating out of a C-corporation or have multiple partners operating out of an S-corporation. This may be opening an even larger question of whether you are operating out of the best entity type for your practice and your personal situation.
A few years ago, I met with a new client and his three partners. These four partners had been working together for the previous 7–8 years and had experienced steady growth year over year. Like many of the practices we see, this one started when the now senior doctor bought a small practice previously owned by a doctor that had let production dip. This new owner brought a new sense of energy to the practice, and it began to grow. As the years went by, the production could not be handled by one doctor, so a second bought in, and eventually a third, then a fourth. The intention was never to grow into a $5 million–plus practice, but it happened. Over this growth period there had been little advice given on salaries or entity type; the doctors just went with “what had been done in the past.” It was quickly realized that a large four-doctor practice cannot operate in the same way a small one-doctor practice can.
One of the factors contributing to the growth in the practice was due to two of the doctors driving their production up while the other two doctors stayed consistent. These differences in production began to cause problems related to money distribution. As noted above, there are generally two ways to take money out of a practice—through salaries and distributions. Operating as an S-corporation with multiple owners, each owner could only take distributions in line with his or her ownership percentage. Thus, if a 25% owner takes $20,000 through distributions, then all owners need to take $20,000.
It was quickly realized that a large four-doctor practice cannot operate in the same way a small one-doctor practice can.
The problem then was that the only way to true-up production discrepancies was to “bonus out” the additional pay through payroll. The larger producers in the practice saw their salaries from the practice rise dramatically over time. Rising payroll salary brought steep payroll taxes, costing my client nearly $25,000 a year.
Knowing payroll taxes was one key area to save money for this client, we created a plan to move the practice out of operating under one S-corporation and into a more optimal entity structure for their specific business. The change in structure allowed for more flexibility on how money is split, as well as the ability to run a lower payroll for all doctors. In addition to other benefits, the new structure allows this client to save $25,000 a year on something as simple as setting his salary. As the business continues to grow, that tax savings increases from year
It is only by looking at the global picture that we can help you determine a salary that lets you live well today and meet tomorrow’s obligations while building a comfortable future. As tax laws change, business cycles fluctuate, and personal expenses evolve, setting your personal salary is an essential way to ensure that your business works for you.
Disclosure: Cain Watters & Associates LLC is an investment advisor registered with the Securities & Exchange Commission. Information provided does not take into account individual financial circumstances and should not be considered investment advice to the reader. Request form ADV Part 2A for a complete description of CWA’s financial planning and investment advisory services. There is no assurance that other client actual results will be similar to information presented. Estimated future results may not be obtained due to economic, business and personal circumstances.