S Corporation Owner Compensation

What You Need to Know

If you own and work in an S corporation, how you pay yourself is important for both tax and legal reasons. Here’s a simple guide to help you understand the rules and stay compliant.

1. What Is “Reasonable Compensation”?

• The IRS requires S corporation owners who work in the business to pay themselves a “reasonable” salary for the work they do.
• Reasonable compensation means paying yourself what you would pay someone else to do your job, with your skills and responsibilities, in your industry and location.
• This salary must be reported on a W-2 and is subject to payroll taxes, just like any other employee’s pay.

2. Salary vs. Distributions: What’s the Difference?

• Salary: This is your regular paycheck for the work you do. It’s subject to Social Security, Medicare, and income tax withholding.
• Distributions: These are payments of the company’s profits to you as a shareholder. Distributions are not subject to payroll taxes.
• You must pay yourself a reasonable salary before taking any distributions. If you pay yourself too little and take most of your money as distributions, the IRS can reclassify those distributions as wages and charge you back taxes and penalties.

3. Best Practices for S Corporation Owner Compensation

• Pay Yourself a Fair Salary: Base your pay on your duties, experience, and what similar jobs pay in your area and industry.
• Keep Good Records: Document how you decided on your salary. Save job descriptions, salary surveys, and notes from meetings.
• Don’t Take Only Distributions: Avoid the mistake of taking all your income as distributions and little or no salary. The IRS may see this as an attempt to avoid payroll taxes.
• Review Your Salary Regularly: As your business grows or your role changes, review and adjust your salary to keep it reasonable.
• Understand Social Security Impact: Paying yourself a very low salary may save on payroll taxes now, but it can also reduce your future Social Security benefits.

4. Common Pitfalls to Avoid

• Setting your salary too low to avoid payroll taxes.
• Taking all profits as distributions without a reasonable salary.
• Failing to document how you set your compensation.
• Not updating your salary as your business or role changes.

Summary

As an S corporation owner, you must pay yourself a reasonable salary for your work, report it on a W-2, and pay payroll taxes. After that, you can take additional profits as distributions, which are not subject to payroll taxes. Keep good records, review your pay regularly, and avoid common mistakes to stay compliant and avoid IRS penalties.