When you own an S corporation, one of the first questions that comes up is, “How should I pay myself?”

Business owners can generally pay themselves with a salary, distributions, or a combination of both. And the way you structure your pay affects your taxes and compliance with IRS rules.

Let’s walk through how S corporation compensation works and how to structure your pay in a way that keeps you out of trouble with the IRS.

How do S Corp owners get paid?

When you own an S corporation and actively work in the business, there are two ways to take money out of the company: salary and shareholder distributions.

Salary or wages

If you’ve ever worked for someone else, you’re likely familiar with a salary or wages. That’s the amount reported on your W-2 at the end of the year.

When you work in your S corporation, the IRS considers you an employee of the company, even if you’re also the owner. That means the business must pay you a reasonable salary, just like it would pay any other employee doing similar work.

The business pays your salary through payroll and withholds Social Security and Medicare taxes. The company also pays the employer portion of payroll taxes just as it would for any other employee.

Shareholder distributions

Distributions are another way to take money from the business. Distributions are profits paid to shareholders. You still pay income taxes on distributions because, as the owner of a pass-through business, you pay income taxes on your share of the company’s profits. But you don’t pay payroll taxes or self-employment taxes on distributions.

This is one of the reasons business owners elect S corporation status in the first place. In some cases, it can reduce self-employment taxes.

However, it’s crucial to keep in mind that the IRS does not allow you to skip salary and take only distributions.

Why does the IRS require a reasonable salary?

Without reasonable compensation requirements, every S corporation owner would simply pay themselves $0 in salary and take all profits as distributions to avoid payroll taxes. But those payroll taxes are necessary to funding Social Security and Medicare benefits.

To prevent payroll tax avoidance, the IRS requires S corporation owners who work in the business to take “reasonable compensation.” A reasonable salary generally reflects the type of work you perform for the company, the time you spend working, your experience and expertise, and what someone else would earn doing the same job.

Think of it this way: if you had to hire someone to replace yourself tomorrow, what would you have to pay them? That’s the ballpark the IRS expects your salary to fall into.

What happens if you don’t pay yourself a reasonable salary?

If the IRS determines you didn’t pay yourself a reasonable salary, it can reclassify some or all of your distributions as wages. This triggers back payroll taxes, penalties, and interest.

In other words, what looked like tax savings can quickly turn into an expensive problem.

How should I pay myself as an S corporation shareholder?

For many S Corp shareholders, the best approach is a combination of salary and distributions.

This means paying yourself a reasonable salary and then taking additional profits as distributions.

For example, say your S corporation generates $150,000 in profit before paying you, and a reasonable salary for your role is $80,000.

In that case, you pay yourself a salary of $80,000, and you can take up to $70,000 in distributions.

You pay income taxes on the entire $150,000 in profit, but only $80,000 is subject to payroll taxes. In the right circumstances, this creates substantial tax savings.

How often should I pay myself?

Some S Corp shareholders wait until December to figure out how much money they’ve taken out of the business and decide how much of that is salary. However, this creates issues with the IRS if it appears you’re artificially structuring your compensation.

Instead, run payroll at least monthly and withhold the correct federal and state taxes from each pay run. Keeping your pay predictable is a win-win because it’s also better for your personal cash flow.

Pay yourself the right way (and sleep better at night)

Paying yourself correctly as an S Corp owner is a balance between paying yourself a reasonable salary for the work you perform and taking additional profits as distributions when available.

Structuring your pay correctly and keeping records to document your decisions can help you save on payroll taxes and stay out of trouble with the IRS.

If you’re not sure how much salary makes sense for your situation, contact NewWay Accounting. We can review your compensation strategy, help you avoid costly mistakes, and ensure your S Corp structure works the way it’s supposed to.

And that’s the goal: keeping more of what you earn while staying on the IRS’s good side.