For many small business owners, electing S corporation status can provide meaningful tax benefits. But it also creates an important question:
How much should an S corporation owner pay themselves as salary, and how much can they take as distributions?
There isn’t a single salary amount or percentage that works for every business. Understanding the distinctionvand reviewing it periodically is an important part of operating an S corporation.
Salary and Distributions Are Not the Same
An owner who works for an S corporation can generally receive money from the business in two primary ways: W-2 wages and shareholder distributions.
W-2 wages are compensation for services the owner performs for the business. They are generally subject to payroll taxes and normal payroll withholding requirements.
Distributions are payments made to the owner in their capacity as a shareholder. Unlike wages, S corporation distributions generally are not subject to Social Security and Medicare payroll taxes.
That difference is one reason S corporation taxation can be attractive—but it is also why owner compensation receives attention from the IRS.
What Is “Reasonable Compensation”?
An S corporation generally must pay a shareholder-employee reasonable compensation for services performed before making non-wage distributions to that shareholder.
There is no universal formula for determining reasonable compensation.
Instead, the appropriate salary depends on the particular facts and circumstances. Factors can include:
- The owner’s responsibilities and duties
- Time devoted to the business
- Experience and expertise
- The type of work performed
- What comparable businesses would pay for similar services
- The company’s size and financial performance
- Compensation paid to other employees
- The local market for comparable positions
For example, an owner who works full-time managing every aspect of a profitable business may warrant very different compensation from an owner who works limited hours and has employees handling most day-to-day operations.
The goal shouldn’t simply be to choose the lowest salary possible. The compensation should be supportable based on the owner’s actual role.
Why Not Take Everything as a Distribution?
Because distributions generally aren’t subject to payroll taxes, it can be tempting to minimize salary and take most of the business’s earnings as distributions.
That can create problems.
If an S corporation pays an owner an unreasonably low salary—or no salary at all—while making significant distributions, the IRS may reclassify some of those distributions as wages.
That can potentially result in additional employment taxes, penalties, and interest.
The better approach is to establish a reasonable salary based on the facts and then properly process that compensation through payroll.
Does That Mean All Remaining Profit Can Be Distributed?
Not necessarily.
An S corporation’s taxable income, cash, and shareholder distributions are related, but they are not the same thing.
A profitable business may need to retain cash for payroll, operating expenses, equipment purchases, debt payments, expansion, or an emergency reserve.
There can also be tax consequences when distributions exceed a shareholder’s basis in the company.
That’s why the question shouldn’t simply be: “How much am I allowed to distribute?”
A better question is: “Given the company’s profitability, cash needs, taxes, and my personal financial situation, how much should I distribute?”
Salary Shouldn’t Be a “Set It and Forget It” Decision
A salary that was reasonable when an S corporation was first established may not remain reasonable several years later.
Suppose an owner initially pays themselves $60,000 when the company is generating $150,000 of annual profit. A few years later, the company is substantially larger, the owner’s responsibilities have increased, and profitability has doubled.
Continuing to use the original salary simply because “that’s what we’ve always done” may no longer make sense.
Owner compensation should be reviewed periodically as the business changes.
Salary and Distributions Are Part of a Larger Tax Plan
Reasonable compensation shouldn’t be considered in isolation.
The amount of W-2 compensation can affect payroll taxes, retirement plan contributions, business cash flow, and the owner’s overall tax situation. Distributions affect cash available to the owner and may have their own tax considerations.
Estimated tax payments also need to account for the income passing through from the S corporation to the shareholder—even when all of that income hasn’t been distributed in cash.
For that reason, salary and distribution planning works best when the business’s accounting, payroll, business tax return, and owner’s personal tax planning are coordinated.
A Better Approach
For an S corporation owner, a good year-round process generally includes:
- Establishing supportable reasonable compensation
- Processing salary properly through payroll
- Monitoring business profitability during the year
- Reviewing distributions and available cash
- Updating tax projections when circumstances materially change
- Reviewing compensation as the business grows or the owner’s role changes
The appropriate balance will be different for every business.
The objective isn’t simply to minimize payroll taxes. It’s to develop a compensation and distribution strategy that is reasonable, tax-efficient, and appropriate for the business and its owners.
Durkin Advisory Group provides accounting, tax, and advisory services to businesses and their owners. We help business owners coordinate accounting, payroll, tax planning, and owner-level decisions throughout the year.
This article is intended for general informational purposes only and does not constitute tax, legal, or financial advice. Tax rules depend on individual facts and circumstances.