Understanding and Optimizing W-2 Income for Practice Owners

Depending on your entity type or tax election, as a practice owner you have multiple ways of recognizing the profitability of your business:

• Sole proprietors recognize profit as pass-through income or utilizing non-cash compensation to offset taxes.
• C corporations can recognize income via W-2 income or dividend payment.
• S corporations have the ability to balance W-2 income, distributions, or non-cash compensation.

Practice owners are often incorporated as an S corporation or, if formed as a PC or LLC, choose to be taxed as an S corporation. This option bestows the greatest level of tax planning for the practice owner, as the balance of W-2 income versus distributions allows practitioners to control self-employment taxes. Many owners aim to reduce the income they recognize as an employee of their practice, commonly known as W-2 income, to avoid paying the Social Security and Medicare taxes associated with it. However, this strategy comes with hidden risks and may not be the most tax-efficient approach.

So, what is an appropriate balance between W-2 income and distributions? First, we should understand the dangers of targeting a W-2 income too low and the costs of pushing W-2 income too high.

The risks of understating W-2 income.

One of the main perils of reducing your W-2 income too much relates to the IRS’s requirement that this revenue must be “reasonable.” But what does this mean? According to the IRS, "Reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances." Clear as mud, right? If the IRS determines that you’ve underpaid yourself, you could face fees, penalties, and back taxes.

A common heuristic is the 60/40 rule, where 60% of profit is paid as W-2 income and 40% as a distribution. Another rule of thumb, depending on your industry, role, and profitability is to consider the Social Security wage base as a potential floor for W-2 compensation, which fell at $176,100 in 2025. Many accountants also use geographically centered databases to compare compensation for similar roles and help set reasonable salaries. With no hard and fast rule for determining a minimum required W-2 income, we should recognize an amount that is defensible within the framework of the IRS’s rough guidelines.

Is there a ceiling for W-2 income?

With some rules established on the W-2 floor, is there a ceiling for how high it should be? Consult your accountant regarding what they consider reasonable, but generally there's no benefit for a W-2 income to exceed the 401(a)(17) limit. This cap represents the maximum amount of wages that can be considered for non-discrimination testing in a qualified plan. For 2025, the 401(a)(17) limit is $350,000. Another consideration for 2025 will be the qualified business income deduction (QBID) phase out window for married couples with taxable income below $394,600. The QBDI provides a 20% tax benefit pass-through income, which is distributable income not recognized as W-2 income. This deduction phases out $483,900 of taxable income. Unless extended, the QBID is currently set to expire at the end of 2025.

Establishing the optimal W-2 income.

With both a floor and a ceiling in mind, how do you determine the right W-2 income? The answer involves a dynamic process.

It’s important to understand some basic concepts when deciding your amount. To begin, your W-2 income does not need to be recognized evenly throughout the year. In addition, there are two advantages to a correctly designated W-2 income: the primary variable used to determine the allocation of employer funding in qualified plans and if it can be used to catch up on tax payments.

Ideally, as a high-income practice owner, you have a safe harbor top-heavy 401(k) plan. Your third-party administrator (TPA) can provide allocation studies that estimate the effects of various W-2 income levels on profit-sharing. This is typically done later in the year, when staff hours and pay for the full year are coming into focus. A savvy practice owner may set a W-2 salary to serve as a base, generally between $200,000 and $225,000. As the annual census is coming into focus, the owner can request a few allocation studies from their TPA to estimate profit sharing allocations based on the impact of raising their income incrementally, say, $250,000, $300,000, and finally at the maximum 401(a)(17) $350,000.

In most cases, you’ll notice the higher your W-2 income, the more you retain in profit-sharing contributions. However, depending on your census, there is a point where the returns diminish. To make an informed decision, compare the additional profit-sharing retention against the employee portion of the Medicare tax rate of 1.45%. If you’re married and your household’s taxable income falls within or below the qualified business income (QBI) phaseout range of $394,600 to $494,600 for 2025, factor in the additional 20% tax reduction on distributed income.

Tax withholdings versus estimate tax payments.

Another overlooked benefit of W-2 income is how tax withholdings differ from estimated tax payments. The IRS wants estimated tax payments to align with earnings throughout the year. While there are a lot of rules around calculating these payments where your accountant can offer guidance, there can be penalties or interest that can accrue if your quarterly payments are not made on a timely basis, even if you pay the full amount before year end. Unfortunately, you cannot go back in time and true up a missed or low estimated payment, but you can utilize your W-2. These withholdings are applied equally to the year, regardless of when the withholding occurs. With the prior strategy, if there is a positive net benefit to increasing your W-2 later in the year to improve your qualified plan retention results, it’s a great opportunity to consult with your accountant to see if this move can be used as a true up on your taxes for the year. When issuing the “bonus” pay, you can override your payroll software to increase tax withholdings and allow you to avoid tax penalties and interest in some cases.

Conclusion

As a practice owner, you have multiple ways of recognizing the profitability of your practice. Determining an appropriate balance between W-2 income and distributions can provide tax savings, if correctly implemented. By understanding risks and regulations, you can create strategies to optimize your income for years to come. If you have questions about how recognizing W-2 income fits your overall financial plan, our team would love to help you. Schedule a conversation with a practice integration advisor today!

Sources:
https://www.irs.gov/pub/irs-drop/n-24-80.pdf[ET9] [AW10] [T(11] [A(12] [13] [AW14] [15]
Qualified business income (QBI) deduction: Overview and FAQs | Thomson Reuters

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