If you’re the owner of an S corporation, chances are you’ve heard conflicting advice about how to pay yourself. Some people say, “Take a low salary to save on taxes.” Others say, “Don’t take any distributions or the IRS will get you.” Like most tax debates, the truth is somewhere in the middle—and it depends on your situation.
As an S corp owner-employee, you’re required to pay yourself a salary. Not a token amount. Not a dollar a year. A reasonable compensation based on what someone else would be paid to do your job. Then, if your business has profits left over, you can take distributions. The balance between the two matters—because it affects your personal taxes, your payroll obligations, and how your business is seen by the IRS.
This post breaks it down in plain English.
Salary vs. Distributions 101
Let’s start with the basics. An S corporation is what’s called a pass-through entity. That means the business itself doesn’t pay income tax. Instead, profits and losses “pass through” to the shareholders (you) and get reported on your personal return.
Here’s the key:
- Wages you pay yourself are subject to payroll taxes (Social Security and Medicare).
- Distributions are not.
That sounds like a great loophole, right? Just skip the salary and pay yourself only in distributions?
Not so fast.
The IRS knows that game. In fact, S corp owners not taking a reasonable salary is one of the top red flags for audit. If you’re doing the work of a full-time employee in your business and not paying yourself accordingly, they’ll reclassify distributions as wages—and hit you with back taxes and penalties.
What Counts as “Reasonable Compensation”?
The IRS doesn’t define “reasonable” with a specific number, which makes it a gray area. But they do expect you to use logic and documentation. Some of the key factors to consider:
- The duties you perform in the business and the time you spend doing them
- What comparable businesses pay for similar roles
- What someone else would be paid to do the same job
- Your business’s industry and size
- What other sources of income you have to sustain your lifestyle
Let’s say you run a basketball training business and handle everything—sessions, marketing, scheduling, and admin. If you were hiring someone to replace you, what would you offer them in salary? That’s your starting point.
There’s no “safe harbor” number, but tax pros will recommend allocating at least 40–60% of your net income to wages. That’s not a rule—but it’s a benchmark that often makes sense.
A Quick Note on Timing
Wages should be paid throughout the year, not in one lump sum at year-end. Regular pay periods like once a month or every two weeks are required, but that doesn’t mean you have to pay yourself the same amount or even the same rate – especially if your business is seasonal. You’ll need to set up payroll, withhold and remit taxes, and file the appropriate payroll returns (like 941s, W-2s, and state reports if applicable). A payroll service provider can help you keep track and file most of this paperwork automatically, usually for a very reasonable (and deductible) fee.
What About Distributions?
Once your reasonable salary is in place, you’re free to take distributions from your business’s profits. This is one of the main tax advantages of S corps: unlike a sole proprietor or single-member LLC that pays the 15.3% self-employment tax on every dollar of profit, an S-corp owner only pays payroll tax on their salary – not on the distribution portion.
But distributions aren’t guaranteed. You can only take them if your business has retained earnings—i.e., the leftover profit from the current or previous years after all the expenses (and wages) were paid.
It is also essential to track your basis, or total investment in your business. In simple terms, each year the business profits increase your basis, while distributions reduce it. If your distributions in any year exceed your basis, then the excess will be subject to capital gains tax.
Here’s an Example
Let’s say you’re a personal trainer running your own S corp. You decide to pay yourself a $45,000 salary through payroll—based on estimated replacement cost, and aligned with industry averages for your role. That means you’ll pay payroll taxes on the $45,000 and issue yourself a W-2.
Now let’s say, you bring in $85,000 in revenue for the year. Subtract that $45,000 salary and another $20,000 in other expenses. That leaves $20,000 net profit available as a distribution.
You’ll still pay ordinary income tax on both the wages you pay yourself and the net profit (because your business profits pass through to your personal return), but only the wages are subject to payroll taxes.
Result? You save thousands in self-employment tax and stay compliant with the IRS.
What If I Don’t Have Enough to Pay Myself?
What if you’re in startup mode? Or your business is barely breaking even?
You’re still technically required to pay yourself something if you’re actively working in the business—even if it’s modest. In low-income years, that could mean a part-time salary, or even result in the business showing a loss for the year. Losses can be carried forward to help offset profits in future years. However, it would be a big red flag if the business shows a loss in a year in which there were distributions, but no salary.
Remember, taking distributions is not mandatory, but paying a reasonable compensation IS.
Here’s a Quick Checklist for S-Corp Owners
Before year-end, make sure you’ve addressed these key points:
- Have I paid myself a salary that reflects the work I perform?
- Did I run that salary through payroll with tax withholdings?
- Have I filed or scheduled my required payroll tax forms (941, 940, W-2)?
- If I took distributions, did I first ensure the business had adequate profit?
- Am I keeping documentation to support how I calculated reasonable compensation?
Don’t Wait Until Tax Time
The biggest mistake I see? People waiting until tax prep season to think about this. By then, it’s too late to fix it.
Wages must be paid during the year, not just “recorded” later. And notice in the example above the wages were calculated before the revenue came in.
If you’re unsure whether your current compensation structure is compliant, talk to your tax professional now. We can help you estimate reasonable wages, set up payroll, and make sure your year-end reporting is right.
Keep It Compliant and Strategic
For S corp owners, how you pay yourself is one of the most important decisions you’ll make. It affects your taxes, your audit risk, and your cash flow. And yet, it’s also one of the most misunderstood areas of small business finance.
You don’t need to be a tax expert, but understanding the basics and getting the right systems in place is essential.
At Varsity Tax Prep, we help coaches, trainers, and small business owners pay themselves properly and stay out of trouble with the IRS—while keeping more of what they earn.
Need help with your S-corp compensation plan? Let’s talk. Schedule a free consultation and get clarity on how to structure your pay, plan for taxes, and build a business that supports your life.
