One of the great things about an S-Corporation is how it handles an owner’s pay. Unlike a regular C-Corp, an S-Corp avoids double taxation. This means profits and losses are passed directly to the owners’ personal tax returns. This avoids being taxed once at the company level and again when you receive money.
However, a key question for S-Corp owners is how to pay themselves: through a W-2 salary or through owner distributions. Knowing the difference and getting the balance right is crucial for saving on taxes and following IRS rules.
How S-Corp Owners Get Paid
If you’re an S-Corp owner who works in the business, you’re both an employee and a shareholder. This is why there are two ways to get paid:
1. Salary (W-2 Wages): This is the money you earn for the work you do for the company. Just like any other employee, your salary is subject to federal and state income taxes, as well as payroll taxes (Social Security and Medicare), also known as FICA taxes. The S-Corp pays half of these payroll taxes, and you, as the employee, pay the other half. The salary you pay yourself is a business expense, which lowers the company’s taxable income.
2. Distributions: After you’ve paid yourself a reasonable salary and covered all other business costs, any remaining profits can be given to you as a distribution. The main benefit here is that these distributions are not subject to the 15.3% payroll tax (FICA). You will still pay personal income tax on them, but you save on the payroll tax portion.
The IRS “Reasonable Compensation” Rule
The IRS has a rule called “reasonable compensation.” The main purpose of this rule is to stop S-Corp owners from paying themselves a very small salary (or no salary at all) just to avoid payroll taxes on distributions. The IRS requires you to pay yourself a “reasonable” salary for the work you do.
What “reasonable” means isn’t a simple formula. The IRS looks at a few things to decide if your salary is fair, such as:
- Your job duties: What tasks you perform for the company.
- Industry pay: What other people in your industry are paid for similar work.
- Your time: How much time you spend working for the business.
- Company health: The size and profits of your business.
If you don’t pay yourself a reasonable salary, the IRS might audit you. They could decide that some of your distributions should have been wages. In that case, you’d have to pay back taxes, plus penalties and interest.
Finding the Right Balance
So, what’s the best way to do it? The goal is to pay a “reasonable” salary while also saving as much as you can on taxes. Many S-Corp owners and tax experts use different methods to figure this out, but here are some common ideas:
- Look at the market: Find out what other professionals in your area and industry make for the same kind of work.
- Talk to a professional: The best approach is to work with an experienced tax expert. They can look at your specific situation and help you figure out a fair salary.
The key thing to remember is that for S-Corp owners who work in their business, paying a salary is a must. You have to pay yourself a reasonable wage before you can take any distributions. By doing this correctly, you can legally save a good amount on taxes while staying on the right side of the IRS.
Need expert help with your S-Corp pay and tax plan?
At Khob Tax, we specialize in business tax preparation for corporations like S-Corps and C-Corps. Our team offers year-round tax planning to help you handle payroll, distributions, and other tax strategies.
Contact us today at 510-742-1419 or Schedule a Consultation to make sure you’re making the smartest tax choices for your business.
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