Small business owners pay themselves via several methods, and those who own an S-corp have access to more personal income options. However, how you pay yourself as an S-Corp owner can make a big difference in your taxes at the end of the year. Why do some S-corp owners choose to pay themselves an owner salary vs. taking distributions?
A topic that frequently comes up in our discussions with small business S-corp owners in Atlanta is whether to take an S-corp owner salary vs. owner distributions and why. Below, our tax experts discuss some best practices for S-corp owners trying to navigate their reasonable compensation.
Definitions of an S-Corp Salary vs. Owner Distributions
Before we get into the detailed tax benefits of each, here are some important definitions:
- An owner salary is money you earn as an employee of your own business. To pay yourself a salary, you will likely use an automated payroll software (like Gusto or Paycor) to pay yourself throughout the year. You’ll also issue yourself a W2 form. As with all salaries, Social Security and Medicare are withheld with each paycheck.
- Owner distributions are taken from the company’s profits. Unlike salary, distributions are generally not subject to Social Security and Medicare taxes. This income is reported on your personal tax return. S-corp owner distributions tend to not follow as strict of a schedule as payroll.
Because distributions are taxed differently, most S-corp owners lower their overall tax bill by using a mix of both types of income. One of the main tax benefits of an S-corp is the ability to take a combination of salary and distributions. Understanding how each works can help you save money and avoid problems with the IRS.
Reasonable Compensation IRS Requirements for S-Corp Owners
According to the IRS, if you actively complete work in your S-corporation, you must pay yourself a reasonable salary before taking distributions. The tricky question is how to define reasonable compensation.
“Wages paid to you as an officer of a corporation should generally be commensurate with your duties,” says the IRS, but that doesn’t necessarily come with a perfect formula. Read more details on how it’s defined, considered, and other complications. Factors like your training, duties, services, and comparable salaries all affect what reasonable compensation might look like for you.
In the simplest terms, your salary should be similar to what you would pay someone else to do the same job. Note that trying to avoid payroll taxes by taking only distributions can lead to severe IRS penalties and additional taxes.
Let’s say your business earns $100,000.
Option 1: Take an S-Corp Owner Salary Only
- Salary: $100,000
In this example, payroll taxes apply to the entire amount.
Option 2: Take a Salary Plus Distribution
- Salary: $60,000
- Distribution: $40,000
In the second example, payroll taxes apply only to the $60,000 salary.
Why Pay Yourself a Salary Only
- You’ll build up more Social Security and Medicare benefits.
- You can do better overall retirement planning, such as paying consistently into a 401(k).
- Not paying yourself enough of a salary or even no salary comes with a higher risk of an audit. Some choose a high salary that’s easily defended for that reason.
Why Take Distributions After Reasonable Compensation
- You can become more flexible with cash flow based on business performance.
- You’ll reduce Social Security and Medicare (FICA) taxes paid upfront.
- You can incorporate maximizing your Qualified Business Income (QBI) benefits into your tax plan.
Other Key Considerations for S-Corp Owners
The IRS closely scrutinizes these S-corp salary vs distribution choices, so documentation is critical. There’s no perfect formula for reasonable compensation, as it depends on many different factors. A good local accountant will likely ask some of these types of questions when determining which strategies for compensation to use:
- How much would it cost to hire someone who does what you do?
- Could the business operate day-to-day without your direct involvement?
- How much profit does the business bring in, and what is the cash flow like?
- Is your business a part of your retirement planning strategy?
- How could you justify your salary with evidence in the event of an audit?
Why Your S-Corp Compensation Plan Should Be Included in Your Yearly Tax Plan
Because salaries are constantly shifting with inflation, industry changes, and experience, revisiting your reasonable compensation should be a part of your annual tax planning strategy. The right S-corp compensation strategy could potentially save you thousands of dollars in taxes while keeping you compliant with IRS rules. Choosing the right balance between salary and distributions can help you lower your tax bill, stay compliant with IRS regulations, and avoid costly penalties.
Every business is different, and there is no single salary amount that works for everyone. A CPA can help determine a reasonable salary and create a tax strategy that maximizes your savings. If you’re unsure whether you’re paying yourself correctly, contact us to get in touch with a professional local accountant today.
