How to Pay Yourself for Maximum Tax Benefit as an MSP Owner (with Morgan Holmes)

This session explores key strategies for MSP owners to maximize tax benefits, focusing on business structures, compensation planning, fringe benefits, and profit distribution.

In a recent Stride Live session, we explored critical tax strategies for MSP (Managed Service Provider) owners with expert insights from CPA Morgan Holmes. The focus of the webinar was on optimizing how business owners compensate themselves to maximize tax efficiency and long-term financial benefits.

If you’re running an MSP with positive cash flow, now is the time to structure your compensation, benefits, and profit distributions with intent. With the right strategy, you can reduce your tax liability while positioning your business for sustainable success.

1. Why Business Structure Matters

One of the foundational decisions for any MSP owner is the choice of business entity. According to Morgan Holmes, the majority of MSPs operate as S Corporations, which offer significant advantages in terms of tax planning—particularly when it comes to how owners pay themselves.

The S Corp structure enables owners to split income between W-2 wages (which are subject to payroll tax) and shareholder distributions (which generally are not). This division can lead to notable tax savings—if handled correctly.

However, this benefit comes with rules. One key requirement for S Corp shareholders is that they must pay themselves a “reasonable compensation” via W-2 wages. Which brings us to the next important point.

2. Understanding “Reasonable Compensation”

“Reasonable compensation” is a concept that the IRS pays close attention to, especially when auditing S Corporations. It refers to the amount of salary an owner-operator must pay themselves that fairly reflects the work they perform for the business.

Morgan Holmes emphasized that reasonable compensation is determined on a case-by-case basis. There’s no fixed percentage or flat rate. Instead, owners need to consider the scope of their responsibilities—sales, operations, hiring, administration, etc.—and estimate what it would cost to hire someone to do the same work.

Geography also plays a role. A business owner in San Francisco might justify a higher salary than someone performing similar duties in a smaller or less expensive market.

Failing to meet the reasonable compensation threshold could expose the business to IRS scrutiny, potential back taxes, and penalties. Conversely, paying too high a salary can reduce eligibility for certain deductions like the Qualified Business Income (QBI) deduction.

3. Beyond Salary: Strategic Use of Benefits

Once an MSP owner sets a reasonable W-2 salary, the next layer of optimization involves leveraging employee benefits for both tax and lifestyle advantages.

Health Insurance and HSAs

Health insurance premiums paid by the business can be deducted, though for S Corp owners they must be reported on the W-2. In addition, if the owner has a High Deductible Health Plan (HDHP), they may contribute to a Health Savings Account (HSA). HSAs offer triple tax benefits: contributions are deductible, growth is tax-free, and withdrawals for medical expenses are tax-free as well.

Importantly, if you’re able to cover medical expenses out-of-pocket now, your HSA can continue to grow tax-free and be used for non-medical purposes after age 65, making it a powerful retirement savings tool.

4. Don’t Overlook Fringe Benefits

Fringe benefits are another tax-efficient way for MSP owners to compensate themselves. These include reimbursements for business use of personal vehicles, home offices, and cell phones—all common scenarios in the MSP space.

To properly take advantage of these deductions, your business should set up an accountable plan. This formal arrangement allows the business to reimburse the owner for qualifying expenses without those reimbursements being treated as taxable income.

Without an accountable plan, the IRS might reclassify these payments as taxable wages. As Morgan Holmes noted, many MSP owners are already using personal assets for business purposes, but few are taking full advantage of this tax strategy.

5. Retirement Planning for You and Your Business

Retirement plans offer one of the most effective ways to defer taxes and build long-term financial security. The most common option for MSP owners is the 401(k) plan. As of 2024, individuals under 50 can contribute up to $23,000 pre-tax, while those 50 and over can contribute up to $30,500 thanks to catch-up contributions.

But don’t stop there. If your business has the cash flow, consider offering profit-sharing contributions. These allow the business to make additional contributions to employees’ 401(k) accounts (including the owner’s) and can raise the total annual contribution limit to $69,000 (or $76,500 for those over 50).

This dual benefit—lowering the company’s taxable income while boosting retirement savings—makes profit sharing a compelling strategy for MSPs with steady profits.

6. Profit Distribution: A Cautionary Approach

After reasonable compensation and benefit allocations are addressed, many MSP owners look to profit distributions as a way to extract remaining income from the business.

Distributions from an S Corp are typically not subject to payroll tax, making them attractive. However, Morgan Holmes cautioned against taking distributions too early or in excess. Before pulling profits, make sure your business retains enough cash to fund at least three months of operations. This buffer ensures that payroll, vendor payments, and other obligations can be met without issue.

7. State-Level Tax Planning: Pass-Through Entity Taxes

One often-overlooked opportunity for MSP owners involves state pass-through entity (PTE) tax elections. After the federal government instituted a $10,000 cap on state and local tax (SALT) deductions, many states responded by allowing pass-through businesses to pay state income tax at the entity level. As of now, around 34 states offer this option.

Here’s how it works: Your business pays the state income tax, receives a deduction on the federal return, and the owner gets a credit on their personal state return. This strategy sidesteps the SALT cap and increases the deductibility of state taxes—potentially leading to significant federal tax savings.

8. A Waterfall Approach to Owner Compensation

Morgan Holmes wrapped up the session with a helpful analogy: think of your compensation strategy as a waterfall.

Start at the top with:

  1. W-2 compensation, ensuring it’s reasonable based on your role and location.
  2. Health and fringe benefits, maximizing deductible options like HSAs and accountable plans.
  3. Retirement contributions, especially using profit-sharing if feasible.
  4. Profit distributions, only after covering operational reserves.
  5. Advanced strategies, such as PTE tax elections for those in eligible states.

Following this sequence helps MSP owners get the most tax-efficient use of their business income while building long-term financial stability.

For further details or to revisit the discussions from our webinar, watch the full video by clicking the button below or contact our experts directly at Stride Services for personalized advice.

How to Pay Yourself for Maximum Tax Benefit as an MSP Owner


This Stride Live Webinar is hosted by Stride Services. Stride is a comprehensive financial solutions provider, specializing in outsourced bookkeeping, accounting, tax, and advisory services for Managed Service Providers.

If you’re interested in being a featured guest on our Live Webinars or if there’s a subject matter expert you’d like us to interview, please let us know!


Show Notes + Transcript:

Casey Seaborn: Email
LinkedIn: Casey Seaborn

Morgan Holmes: Email
LinkedIn: Morgan Holmes

Webinar Transcript:

How to Pay Yourself for Maximum Tax Benefit as an MSP Owner

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