An S corp offers business owners three ways for paying themselves: distributions, salary, or a combo of both. Choosing which option is best has a lot to do with how you contribute to the company and how well the business does financially. Let’s take a closer look.
Why are payment structures for an S corp different from other business structures?
An S corp’s unique payment structure allows businesses to shield themselves from liability and get the most out of tax benefits.
In other words, an S corp owner and shareholders aren’t personally responsible for the business’s debts, unlike in a partnership or sole proprietorship. That means that your personal assets are protected if your company is sued or can’t pay its creditors.
With an S corp, corporate profits and losses pass through to the shareholders, just like in a partnership or an LLC. As a result, business income is not subject to corporate tax—instead, the shareholders pay taxes on those profits when filing their personal income taxes.
Additionally, while owners of sole proprietorships, LLCs, and partnerships pay self-employment taxes on their total business profits, S corps only pay self-employment taxes on their wages. All other income goes to shareholders as distributions. Because these distributions are not subject to self-employment tax, the S corp structure is very popular with many small business owners.
If you’re wondering why S corp owners don’t just take zero pay to avoid self-employment taxes altogether, there’s a catch. If you’re a shareholder and an employee of a company (which most small business shareholders are), the IRS says you must give yourself a “reasonable salary” before giving yourself a tax-free distribution.
Further reading: Choosing a Business Structure: What’s Right For You
How do you determine a “reasonable salary”?
The rule of thumb on setting your compensation is that it must be “reasonable.” The IRS describes reasonable compensation as:
“An amount that would ordinarily be paid for like services by like organizations in like circumstances.”
In a nutshell:Pay yourself an amount similar to what businesses in the same industry pay for the same work and experience.
Here are a few other factors to consider when choosing a salary that’s comfortable for you and acceptable to the IRS:
· Your qualifications and relevant training
· How many years of experience you have
· Your industry and scope of your work
· Your business size and type of business
· The salary of people in similar roles
· Location and cost of living
All of that is to say, if you’re looking to calculate your salary, it’s important to do your research first. There are industry statistics and various tools available to help you determine the number that’s right for you. Check out the Bureau of Labor Statistics and RCReports, as well as employer-review sites like Glassdoor, Salary.com, LinkedIn Salary, and PayScale.
Three ways to pay yourself: salary, distributions, or both
S corp owners who handle business operations fill two roles: shareholder and employee. But owners who don’t manage daily operations are considered only shareholders. Under an S corp structure, your role directly affects your pay. You can collect earnings in three ways:
- An employee salary
- Shareholder distributions
- A hybrid of the two
Option 1: Pay yourself an employee salary
If you perform employee-like functions at your company, you must draw a W-2 salary that allows you to properly report and pay employment taxes. This is an IRS requirement regardless of whether you also get compensation as a shareholder, like distributions (we’ll touch on that a little later.)
There are many advantages to paying yourself a set salary. Each month, you know exactly how much company money is paid to you versus taking it from the business account every time you need money. This makes it easier to manage cash flow and track expenses. On a personal level, earning a salary shows a steady source of income (which is useful when applying for a mortgage or anything credit-related).
As mentioned earlier, the IRS says that S corp employees must receive reasonable compensation that is equal to a salary that’s paid by similar businesses for the same experience, but isn’t so low that you avoid paying certain taxes.
If the IRS determines that a shareholder’s compensation doesn’t meet “reasonable compensation” status, they can penalize the S corp owners for failing to withhold and deposit employment taxes, and impose a penalty for back taxes owed.
One additional note regarding S corp salary: It’s a good idea to be ready to provide any documents or data you used to come up with your compensation number, just in case the IRS audits you.
Option 2: Pay yourself shareholder distributions
If you’re not active in your company’s operations and don’t provide services to the S corp, you can draw money from the business by using shareholder distributions rather than a salary.
A distribution is a payment of earnings to shareholders, usually in the form of cash or stock, and is taxed at the shareholder level. Unlike a salary, distributions aren’t subject to payroll taxes, employment taxes, Social Security, or Medicare taxes. Instead, they’re taxed on the shareholder’s individual income tax return.
The benefit of taking distributions is that it gives you more flexibility with your wages, allowing you to adjust your compensation based on your company’s performance.
You don’t pay taxes on shareholder distributions until you go over stock basis—the amount of money that you initially invested in the business. Once you go beyond that number, you’re obligated to pay up.
Unlike a C corporation stock basis, which stays the same each year, an S corp’s stock basis can constantly fluctuate through business gains and losses.
That’s why it’s important for you to track your stock basis often so you can correctly report your distributive shares of profit and loss on your personal income tax returns.
Option 3: Pay yourself salary and distributions
If you’re an owner and shareholder-employee, you can pay yourself through a hybrid of distributions and wages as long as your pay matches with the work you’re doing. Additional profits can be taken as distributions, which have a lower tax bill.
Here’s an example: You earn a net income of $160,000. $60,000 of that it through salary, and $100,000 is in distributions, because your responsibilities qualify you as an employee.
Distributions aren’t subject to employment taxes, as long as your salary meets the reasonable salary rules. However, if you don’t follow the rules, the IRS can reclassify other compensation as taxable income.
Before choosing this option, it’s always a good idea to consult with a chartered professional accountant (CPA) to understand how a reasonable salary works in your state.
How Bench can help
As America’s largest professional bookkeeping service for small businesses, we can handle your bookkeeping and tax filing for you while you focus on your business.
If you’re not sure how to handle paying yourself when you start (or switch to) an S corp, you can end up with inaccuracies in your books that lead to larger tax problems later. Your Bench bookkeeping team will keep your financials up-to-date so you’re making informed decisions and complying with any new requirements.
We’ll walk you through what a change in structure means for your business, as well as keep your books up to IRS standards. Add in our tax filing solution, and you’ll gain year-round tax advisory support in addition to an all-star team to prep and file your tax return.
Pay yourself right
S corps can be a clever way to save on business taxes, especially when it comes to paying yourself. At the end of the day, the ultimate goal is to meet your tax obligations while also being paid what you’re worth.
Making that decision, however, is dependent on many factors. Be sure to assess your own needs and choose according to what suits your personal and business situation. Once you’ve nailed that down, you can continue focusing on the other tasks you need to do to grow your business.