Salary vs Distribution: How Should You Pay Yourself?

s corp owner reviewing the differences between salary and distribution

If you own and work within your S-Corp, you’re often faced with some serious decisions. One of the greatest is how much to pay yourself and how much you can take as distributions. What is your value as an employee, and how much can you pull out as an owner?

Your pay as an owner will be a combination of salary matching your activity in the company and distributions exempt from self-employment taxes. Properly balancing the two could result in savings of thousands, while a misunderstanding could trigger an audit and penalties.

So, how do you balance what you should reasonably pay yourself while saving money on self-employment taxes?

 

The Right Ratio Between Salary and Distribution

 

If you look online, there are prevailing concepts of what a safe ratio to pay a founder is that supposedly balances salary and distribution. It’d be fabulous if it were that easy. Still, that ratio can be incredibly fluid based on where the company is in its lifespan, its industry, and what the financials and past actions represent for the company’s future.

There are many variables based on the company type and its growth expectations. Getting that salary amount correct based on so many factors is essential and has the potential for tremendous tax savings.

 

S Corp Distributions vs Salary

 

An S Corp shareholder is subject to tax standards based on the shareholder’s involvement or lack of involvement in the business. If the shareholder has even minimal involvement in the business and offers specific expertise that advances the company, it is essential to calculate what is a reasonable wage.

If a majority owner runs the company and has experience, education, and exceptional skills that are sought after, a reasonable salary versus distribution could be very difficult to establish.

In every situation of distribution vs salary, it all comes down to what specific services are offered by the owner, whether they are replaceable, and whether the salary is reasonable.

The savings can be substantial if the involved shareholder gets the reasonable compensation equation right.

If the shareholder works in the business and is paid a reasonable wage, employment taxes needn’t be paid on distributions.

 

Benefits of Paying Distributions

 

Distributions can be wonderful, especially for those who work within the business. Regardless, an S Corp is a pass-through entity, and all owners will receive a distribution when authorized by the directors that commiserate with their percentage of ownership. The primary benefit for those active within the business is that they do not pay self-employment taxes on their distributions, which can total another 15.3% in taxes.[1]

Those owners taking a wage will pay half of the 15.3% of their salaries. The half paid by the company will also be a write-off as it goes against overall profits. Any amount given as a distribution above the owner’s salary will not be subject to employment taxes.

 

Paying the Price of Tax Breaks

When business owners pay themselves through distributions, they can avoid payroll taxes if their compensation aligns with industry standards for their role. However, underpaying themselves could trigger IRS scrutiny, leading to back taxes and penalties.

s corp owner with his hand to his head feeling stressed because of IRS scrutiny

While distributions are taxed at the shareholder’s rate, there are inherent risks to consider.

If the shareholder is also an employee of the business, their distribution will come with zero payroll tax liability if the owner/employee has been paying themself an amount that would be considered equivalent to the amount paid to someone of certain skills, education, time commitment, and experience. Otherwise, there is a potential for the IRS to audit and assess back taxes and penalties on the unpaid employment taxes if the owner has underpaid themself. [2]

Tax breaks are fantastic, but if abused or misjudged regarding “reasonable” compensation, they can result in interest and penalties.

 

Revisiting the Right Ratio Between Salary and Distribution

 

By structuring compensation appropriately, business owners can potentially minimize tax liabilities for both themselves and the company. This involves striking a balance that reduces payroll taxes while still providing adequate income. Moreover, ensuring compliance with IRS regulations for reasonable compensation is essential. Failing to do so could result in audits, penalties, and back taxes, potentially jeopardizing the financial stability of the business. [3]

When assessing reasonable compensation for an owner/employee of an S corporation, several factors come into play:

  • Credentials and Expertise: It’s important to examine the individual’s qualifications and skills relevant to their role within the company. For example, a CEO with extensive industry experience may warrant higher compensation than a junior manager.
  • Responsibilities: The scope and complexity of the individual’s duties are crucial. For instance, a CFO overseeing financial strategies and compliance may merit higher compensation compared to a clerical staff member.
  • Business Operations: The size and intricacy of the company’s operations play a significant role. A larger corporation with multiple divisions and a global presence may justify higher compensation for its executives.
  • Company Income: The employee’s salary should align with the company’s overall income and financial performance. If the business generates substantial revenue, executives may expect higher compensation packages.
  • Economic Climate: External economic factors, such as market conditions and industry trends, can influence compensation decisions. In times of economic prosperity, companies may offer more competitive salaries to retain top talent.
  • Comparison to Distributions: Courts consider how salaries compare to distributions to stockholders. Discrepancies between executive compensation and shareholder distributions may raise red flags.
  • Compensation Practices: The company’s overall compensation practices for all employees are taken into account. Consistency in salary structures and fairness across the organization are important considerations.
  • Historical Compensation: The employee’s past compensation within the organization provides context. Significant fluctuations in compensation without corresponding changes in responsibilities may draw scrutiny.

So, how does an owner know the proper ratio between salary and distributions? Achieving the optimal balance requires careful consideration of various factors such as the owner’s role within the company, industry standards, tax implications, and the financial health of the business. 

S corp owner on the phone with RCReports getting expert help to learn what his proper compensation would be

Consulting with financial experts and leveraging tools like RC Reports can provide valuable insights and guidance in determining the right compensation structure. By thoroughly analyzing these factors and staying informed about regulatory requirements,

owners can make informed decisions to ensure both tax efficiency and compliance with IRS guidelines.

If you’re a business owner or accounting professional, let RCReports help you find the correct compensation levels based on our years of experience and data. 

Contact RC Reports today for a demo and see how to get owner compensation right every time.

Sources

 

  1. Internal Revenue Service. (n.d.). Self-Employment Tax (Social Security and 

Medicare Taxes). https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes

  1. S Corp Shareholder Distributions: Everything to Know. (n.d.). UpCounsel. 

https://www.upcounsel.com/s-corp-shareholder-distributions

  1. Freeman, J. (n.d.). Clarifying the Contours of “Reasonable Compensation.” 

Freeman Law. https://freemanlaw.com/clarifying-the-contours-of-reasonable-compensation/

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