How Do I Pay Myself as an S Corp? 3 Ways

Once your small business has reached a certain threshold of revenue and stability, it may be a smart to incorporate your business and convert to an S corp for the tax advantages. However, this invites some complexity and rules when it comes to paying yourself and taking advantage of those tax breaks. Not to worry! We’ve got you covered. 

In this article, we’ll cover what S corp owners need to know when setting up their payment structures, the three main options for paying yourself as an S corp, and how to stay compliant throughout the process.

What is an S corp?

An S corporation (or S corp) is a legal business entity available to small businesses with 100 or fewer shareholders. S corps are attractive because they allow for legal separation between an individual and their business, limiting the operator’s personal liability in the event of legal or financial issues. The business structure also allows smaller companies to take advantage of the benefits of incorporation without being subject to the double taxation that hits larger C corporations, that have to pay both corporate and individual income taxes. 

S corps, along with limited liability companies (LLCs), are pass-through entities—so called because they pass through their taxable income, deductions, and losses directly through to their shareholders. In other words, instead of paying taxes on business income, pass-through entities pay the shareholders, who in turn are responsible for paying taxes on their individual returns. 

What’s more, S corp owners only have to pay self-employment taxes, which are 15.3% of your taxable earnings, on their employment wages rather than on the business’s full profits. For these reasons, it’s vital that S corp owners pay themselves at a reasonable rate, because this ultimately determines their tax liability.

Ways to pay yourself as an S corp

So we’ve covered how important paying yourself is as an S corp owner. How you pay yourself depends on your position and responsibilities within the company. You can either be:

• A company employee,
• A shareholder,
• Or both

Employees are paid via a salary of wages or reasonable compensation, while shareholders can take a distribution of the company’s profits. If you own a business but do not play a role in its day-to-day operations, you may be classified as a shareholder. If you hold a position within the company and are involved in its operations, you are an employee and can receive a salary. Some S corp owners may operate as a hybrid of the two. Let’s take a closer look.

Salary

S corp owners have the option of paying themselves a regular salary if they are involved in their business’s daily operations. As an employee of the company, you are required by the IRS to receive a salary and file a W-2 to report your wages so that employment taxes can be accurately determined and paid. As the amount of wages determines the taxes owed, it’s important that you pay yourself enough to clear any tax requirements. More on this later. 

A salary makes sense for S corp owners who are actively involved in their business, and for those who need or prefer a consistent monthly income. This can have benefits for cash flow management and expense tracking. A salary can also demonstrate a steady source of income should you need proof while applying for lines of credit. 

When it comes to how much tax this avenue results in, that will depend on your income. Remember, as a pass-through entity, S corp taxes are reported and paid on your individual tax return. How much you pay yourself, what you earn from other income sources, and your filing status determine your tax bracket. 

Distributions

A distribution is a payment of business earnings, usually either cash or stock, to a company’s shareholders. If you’re an S corp owner with a profitable business—and you don’t take part in your company’s operations as an employee, i.e. you are only a shareholder—you can take distributions of your business’s earnings as payment. Distributions are not subject to payroll or employment taxes, but you do have to report them on your individual income tax returns. 

The benefit of distributions is that they can be adjusted over time to reflect your company’s gains or losses. You can take more when the company has a surplus of profits or less when cash flow is tight. Distributions can also be taken as needed rather than on a fixed schedule, a flexible arrangement that some S corp owners may prefer.

Note: Distributions do not incur additional taxes until you’ve exceeded the stock basis, which is the amount of money you initially invested in the business. After this point, distributions will receive additional taxation. If you choose to take distributions, be aware of your stock basis and track any income you receive to ensure you’re aware of your tax obligations.

Salary and distributions

S corp owners can be shareholder-employees, meaning they are eligible to receive both salary and distributions. As an employee, you receive your regular salary for services provided to the company, but when the business is doing well, you can also take a distribution of the profits without paying any employment taxes on that sum. 

How do you determine an effective split between the two different types of compensation? One common split is to take 60% as salary and 40% as distributions. Others may take a 50/50 split of equivalent salary and distributions. These are often touted splits, but they do not actually fall in line with any IRS recommendations.

Whatever split you choose, a “reasonable” salary is a foundational requirement and the most important factor to ensure this arrangement remains above board. That’s because it is possible to take a lower salary and higher distributions to increase your income without paying the requisite employment taxes. This can lead to trouble with the IRS; if your salary is too low and distributions too high, they may decide to subject a portion of your distributions to payroll taxes. Depending on the amounts you’re working with, this penalty can be sizable. So let’s discuss what exactly a reasonable salary looks like next.

How to determine reasonable salary

According to the IRS, “Reasonable compensation” is the value that would ordinarily be paid for like services by like enterprises under like circumstances. Reasonableness is determined based on all the facts and circumstances.”

As an S corp owner and employee, you must ensure that what you are being paid is on par with what an employee with a similar title and responsibilities in another company in your industry might be paid. Factors you may want to consider include:

• Your years in the industry
• Prior relevant experience
• Business size
• Scope of work
• Local cost of living

Financial literacy coach Jamie Trull describes three different approaches that can help you set a reasonable salary:

• Cost approach: As a business owner, you likely wear many hats and conduct a variety of tasks on a day-to-day basis. This approach involves detailed tracking of each job you perform for the business and using salary data to determine the total value of the work you are doing. A CPA can help you determine the value, or you can use reporting tools to gather the data, like this study Trull created with RC Reports.
• Market approach: This simply involves market research to determine the average salary for your role within the company, using tools like the U.S. Bureau of Labor Statistics, PayScale, or Salary.com.
• Income approach: Finally, the income approach doesn’t involve research. Instead, you calculate how much profit would be satisfactory for an external investor and ensure that amount is met by the business. The assumption is that so long as external investors are satisfied, the salary you are taking is appropriate. Trull mentions that this approach is the flimsiest and may be hard to justify to the IRS. 

How to make S corp salary payments to yourself

Now that you have determined your reasonable salary, it’s time to get paid! Setting up your salary as an S corp owner is similar to setting up payroll for any other employee of your business. Here are a few steps you need to take first:

• Obtain your EIN or Employer Identification Number. You can apply online.
• Register as an employer with your state’s labor department and comply with any state tax requirements.
• Choose a payroll schedule, aka your salary frequency. Do you want to pay yourself and your team weekly, bi-weekly, semi-monthly, or monthly?
• Choose a payroll method. You can do payroll in-house—either by yourself or someone you hire—you can work with an accountant, or you can use a payroll provider.

Once you’ve got these steps squared away, here’s how you actually pay yourself:

1. Calculate your gross wages. This is the amount that you will be paid in a single pay period before any deductions or tax withholdings. Take your annual salary and divide by the number of pay periods in a year. 
2. Calculate and subtract any pre-tax deductions, including retirement contributions, health insurance, or other benefits.
3. Calculate and withhold FICA taxes, federal income taxes, and any state and local taxes (check with your state’s labor department for these).
4. Subtract any post-tax voluntary or mandatory payroll deductions, like union dues or wage garnishments.
5. Pay yourself! Provide a pay stub and either a paycheck or direct deposit.
6. Deposit withheld taxes with the appropriate agencies on time.
7. Record your payroll totals, including the following:
   1. Gross pay
   2. Voluntary deductions
   3. FICA payroll taxes
   4. Federal, state, and local withholdings
   5. Wage garnishment totals 

As you can see, managing your own payroll can get complicated. Luckily there are many folks out there who can help, from qualified accountants to payroll providers like Gusto. 

How to report your salary on your taxes

As we’ve mentioned, when paying yourself, it’s important to file the proper forms to the IRS to ensure you’re compliant with their tax requirements.

If you take a salary, you or your payroll provider must compile and file form W-2 by January 31 each year to report your annual wages. This is the amount you will also report on form 1040 when filing your individual income tax return by the annual tax deadline.

If you take distributions, use form 1120S for reporting. This form includes your business’s income, gains, losses, deductions, and credits for the year. It also includes a Schedule K-1 for each shareholder, which reports your share of the business’s income, deductions, and credits.

There’s a lot involved in paying yourself appropriately, reporting it accurately, and maximizing your tax advantage. IRS fines are no laughing matter, so regardless of which payroll method you choose, we always recommend working with an accountant to ensure each part of this process is up to code and benefiting your business.