Once your business is consistently profitable, becoming an S corporation can offer you pretty exciting tax savings. However, how you pay yourself is important. First, it’s critical you comply with IRS rules (obviously). Next, the method (and amount) you choose to compensate yourself is a key part of your overall tax strategy.
This guide explains the three primary ways S corp owners receive compensation, when each method applies, and how to stay compliant while preserving your tax benefits.
What is an S corporation?
An S corporation is a tax election available to eligible businesses with up to 100 shareholders. It combines liability protection with pass-through taxation, allowing business income, deductions, and credits to go directly to shareholders instead of being taxed at the corporate level.
Unlike traditional corporations, an S corp generally avoids federal double taxation because profits are reported on each owner's individual tax return.
One of the biggest advantages is that payroll taxes apply only to wages paid as salary, while eligible profit distributions are not subject to self-employment taxes. This makes compensation planning an important part of operating an S corp.
An important note: an S corp can be made up of one person (a solo operator who is the owner and the employee) or it can be configured to accommodate multiple owners (up to 100) and multiple employees.
Ways to pay yourself as an S corp owner
Depending on your involvement in the business, you may receive compensation through salary, distributions, or a combination of both.
Your Role | How You Are Paid | Tax Obligations |
Employee | Salary or wages | Subject to payroll taxes |
Shareholder | Profit distributions | Not subject to payroll taxes |
Employee and shareholder | Salary plus distributions | Salary is subject to payroll taxes and distributions generally are not |
If you actively work in the business, the IRS expects you to receive reasonable compensation through payroll before taking distributions. If you are only an investor, distributions may be appropriate without receiving wages.
Paying yourself a salary
Owners who perform services for their S corp must receive a reasonable salary. The IRS defines reasonable compensation as the amount another business would typically pay someone performing similar work under similar circumstances.
Receiving a salary provides consistent income, supports payroll tax compliance, and may strengthen loan or financing applications because it creates documented earned income.
Your salary also affects payroll taxes and your personal taxable income. Since S corp income passes through to your individual return, your overall tax position depends on both salary and business profits.
Paying yourself through distributions
Distributions represent your share of company profits. They are generally available after the business has met its payroll obligations and generated earnings.
Unlike wages, distributions are not subject to payroll taxes, making them an important tax planning tool for many S corp owners. However, they are still reported on your individual tax return through Schedule K-1.
Distributions do not have to follow a regular payment schedule and may vary throughout the year based on profitability. If total distributions exceed your stock basis, the excess amount may become taxable.
Quick reference questions:
Question | Answer |
|---|---|
Are distributions subject to payroll taxes? | Generally no |
Are distributions reported on your tax return? | Yes |
Can distributions vary during the year? | Yes |
Can distributions exceed stock basis without tax consequences? | No |
Salary and distribution combination
Many S corp owners choose a combination of salary and distributions because it balances compliance with tax savings.
While some businesses use estimated salary percentages, the IRS does not recommend a specific formula. Instead, the focus remains on whether your salary accurately reflects the work you perform.
If your salary is unreasonably low and most compensation is taken through distributions, the IRS may reclassify those payments as wages. This can result in additional payroll taxes, interest, and penalties.
Determining a reasonable salary
There is no single salary amount that applies to every S corp. Finding the right number depends on your role, industry, and business performance.
Factors commonly considered include:
Your experience and qualifications
Business revenue and profitability
Typical compensation for similar positions in your market
The time and responsibilities involved in managing the business
Three common methods help determine reasonable compensation.
Method | Description | Best For |
Cost Approach | Calculate the value to the work you perform across all your different responsibilities | Owners who manage many aspects of their business |
Market Approach | Research average salaries for similar roles using tools like PayScale or the Bureau of Labor Statistics | Business owners seeking market benchmarks |
Income Approach | Base your salary on what an external investor would consider acceptable | Business owners prioritizing financial performance abd return on investment metrics |
Working with a CPA or payroll professional can help validate your compensation if your business is ever reviewed.
Setting up S corp payroll
Once your salary amount is determined, set up payroll just as you would for any employee.
Typical steps include:
Obtain an Employer Identification Number (EIN) from the IRS.
Register with your state labor department and comply with state payroll tax laws.
Choose a payroll frequency such as weekly, biweekly, or monthly.
Decide whether to manage payroll internally or through a payroll provider.
Calculate gross wages and apply deductions for benefits and withholdings.
Submit payroll taxes to the IRS and relevant state agencies on time.
Keep detailed payroll records for tax filing and compliance.
Issue Form W2 to employees every year
Using a payroll service can simplify these steps and reduce errors. Many S corp owners use tools like Gusto or consult their accountants for support.
Reporting income and staying compliant
To remain compliant, ensure that your payments are accurately reported to the IRS.
If you take a salary, file Form W-2 by January 31 each year and report the amount on Form 1040 when filing your personal taxes.
If you take distributions, report them using Form 1120-S, which summarizes the company’s income and includes Schedule K-1 to detail each shareholder’s share of profits.
Failure to report accurately or pay yourself a reasonable salary can result in penalties. Partnering with a certified accountant ensures that all documentation aligns with IRS requirements and that you maximize available tax benefits.
FAQs
Can I skip paying myself a salary to save on taxes?
No. The IRS requires active S corp owners to take a reasonable salary for the work they perform.
Can I change my salary during the year?
Yes, you can adjust your salary if business conditions change, but keep detailed documentation supporting the adjustment.
Are distributions always tax free?
Distributions are tax free only up to your investment amount in the business. Amounts beyond that are taxable.
Do I need payroll software to pay myself?
It is not required, but payroll software helps automate calculations, tax filings, and withholdings accurately.
Do I need payroll software to pay my employees?
Same answer as above; payroll sofware is not required, but it can simplify payroll calculations, tax filings, and recordkeeping for S corp owners.
What happens if my S corp is not profitable?
If there are no profits, you may only pay yourself through wages, not distributions.
Video: How and Why You Have to Pay Yourself as an S-Corp Owner
HOW and WHY You Have to Pay Yourself as an S-Corp Owner
