How to Pay Yourself as a Contractor Without Getting Destroyed by Taxes

Most trade contractors fall into one of two camps when it comes to paying themselves: they either pay themselves too much in W-2 salary and overpay self-employment taxes by tens of thousands of dollars, or they take random owner draws whenever they need cash and get hammered with a surprise tax bill in April. Neither approach is optimal.

The right compensation structure—especially for contractors doing $3M–$8M in revenue—can save $20,000 to $50,000+ in taxes annually. The principles are straightforward once you understand how the pieces fit together.

The S-Corp Advantage

If you have not already elected S-Corp status for your LLC or corporation, that is the first conversation to have with your tax advisor. The mechanics are covered in depth in our post on S-Corp elections for trade contractors, but the key concept is this: an S-Corp allows you to split business income between salary (subject to payroll taxes—Social Security and Medicare totaling 15.3%) and distributions (not subject to payroll taxes).

On $400K in business net income, the difference between paying self-employment tax on all of it versus structuring it through an S-Corp with a reasonable salary is roughly $20,000–$30,000 per year in direct tax savings. Over a decade, that is $200K–$300K that stays in your pocket or your retirement accounts instead of going to the IRS.

Setting a "Reasonable Salary"

The IRS requires S-Corp owners who work in the business to pay themselves a "reasonable salary" before taking distributions. This is the number that generates the most anxiety—and the most mistakes.

What qualifies as reasonable depends on your role, your market, and what comparable compensation looks like for someone performing your functions. For a trade contractor who is functioning as president and general manager of a $3M–$8M company—overseeing operations, sales, and strategy—a reasonable salary typically falls in the range of $100,000 to $180,000 depending on your geographic market and the scope of your role.

Set it too low and you risk an IRS audit and reclassification of distributions as wages (plus penalties and interest). Set it too high and you are voluntarily overpaying payroll taxes on income that could have been distributed. The goal is defensible accuracy—a number you can justify with market data if ever questioned.

The Optimal Compensation Structure

Here is how a well-structured compensation plan looks for an S-Corp owner with $400K in available business income:

• W-2 Salary: $130,000 — Subject to FICA/Medicare payroll taxes (approximately $19,890 in combined employer and employee tax). This is the reasonable compensation component.
• Shareholder Distributions: $200,000 — Paid from S-Corp profits, not subject to payroll taxes. This is where the primary tax savings occur—approximately $15,300 in avoided self-employment tax compared to taking this amount as salary.
• Retirement Contributions: $50,000 — Tax-deferred through a Solo 401(k) or SEP IRA. This reduces your current-year taxable income dollar for dollar.
• Tax Reserve: $20,000 — Set aside in a separate account for quarterly estimated tax payments on the distribution and investment income.

The Retirement Accelerator

Most trade contractors are underutilizing the most powerful tax shelter available to business owners: qualified retirement plans. The tax benefits of retirement contributions for S-Corp owners are substantial:

• Solo 401(k): Up to $69,000 per year in combined employee deferral ($23,000, or $30,500 if over 50) plus employer profit-sharing contributions (up to 25% of W-2 salary). This is the best option for most owner-operators because it maximizes total contribution room.
• SEP IRA: Employer contributions up to 25% of W-2 compensation. Simpler to administer than a 401(k) but no employee deferral component, which limits the total contribution for most owners.
• Defined Benefit Plan: For contractors over 50 with consistently high income, a defined benefit plan can shelter $200,000+ per year. The setup and administration costs are higher, but the tax savings at high income levels are extraordinary.

A $50,000 annual retirement contribution at an effective 35% marginal tax rate saves $17,500 in current-year taxes while building wealth that compounds tax-deferred for decades. Over 15 years at 8% growth, that annual $50K contribution becomes $1.4 million in retirement assets—built entirely from money that would have otherwise gone to taxes.

Quarterly Estimated Tax Payments

Nothing destroys a contractor's cash flow like a surprise six-figure tax bill in April. If you are earning income above your W-2 salary—through distributions, investment income, or spousal income—you owe quarterly estimated taxes. Miss the quarterly payments and you will pay underpayment penalties on top of the tax itself.

The system is simple: set up a dedicated savings account. Transfer your estimated tax amount monthly (most contractors find monthly easier to manage than quarterly). Pay the IRS and your state quarterly on the prescribed dates (April 15, June 15, September 15, January 15). This single discipline eliminates the April cash crunch that catches trade contractors off guard every single year.

Your tax advisor can calculate the quarterly amount using last year's tax liability (safe harbor method) or a projection of current-year income. Either approach works—the important thing is that you are paying systematically rather than scrambling.

Common Mistakes to Avoid

• Taking all income as salary. Overpays payroll taxes by five figures annually. If you are still filing as a sole proprietor or single-member LLC without S-Corp election, this is likely your current situation.
• Setting salary too low. A $40K salary for someone running a $5M company is not defensible. It draws IRS attention and creates exposure to reclassification.
• Ignoring retirement plans. Every year without contributions is tax savings permanently lost. Even $20K per year in a Solo 401(k) saves $7,000+ in taxes annually.
• No estimated payments. The April surprise is completely preventable. Pay quarterly or face penalties and cash flow chaos.
• Commingling personal and business finances. Personal charges on business cards, business deposits into personal accounts. This creates accounting nightmares and weakens the legal separation that protects you.

The Bottom Line

How you take money out of your business matters as much as how much you earn. The right combination of reasonable salary, tax-efficient distributions, maximized retirement contributions, and disciplined estimated payments can save five figures annually while building long-term wealth. If your current approach is "take money when I need it and figure out taxes in April," you are leaving tens of thousands of dollars on the table every year. This is one of the highest-ROI conversations you can have with a qualified tax advisor who understands contractor-specific strategies.