S-Corp Salary vs. Distributions: Reasonable Compensation First

THE HEADLINE RULE, BEFORE ANY STRATEGY: an S-corporation owner who works in the business must take a REASONABLE SALARY — paid through payroll, as W-2 wages, with payroll taxes — before taking distributions. This is not a planning preference; it is an IRS enforcement priority. The IRS and the courts have repeatedly reclassified 'distributions' as wages when the salary was a token amount, adding back payroll taxes, penalties, and interest.

WHAT 'REASONABLE' MEANS: roughly what a comparable business would pay a comparable person to do the same work — your duties, hours, experience, and local market. There is no safe percentage and no rule of thumb in the law. What protects you is documentation: a salary survey, comparable job postings, or a compensation study kept in the company file, reviewed when the job changes.

THE LAWFUL SAVING, IN ITS PROPER PLACE: after a reasonable salary, remaining profit can be distributed without payroll or self-employment tax — that is the legitimate S-corp advantage, and it is claimed only on the far side of the salary rule. Salary also does real work for you: it builds Social Security credits and creates the compensation that retirement-plan contributions are measured from. Distributions beyond your stock basis, by contrast, can be taxable.

Common mistakes: taking a $0 salary alongside large distributions; running 'salary' once in December with no payroll filings during the year (Forms 941, the W-2, and state unemployment filings still apply); and setting pay by copying a percentage seen online instead of documenting the market for the actual job.