Distribution vs Salary: Key Differences and Tax Implications
Understand the key differences between salary and distributions, their tax implications, and how they impact business owners and employees differently.
Business owners deciding how to pay themselves must choose between a salary, distributions, or both. This decision affects taxes, cash flow, and IRS compliance. Understanding the differences between the two helps owners optimize compensation while adhering to legal requirements.
Role of Salary in a Company
A salary is a fixed payment for work performed. For business owners involved in daily operations, taking a salary ensures consistent income and compliance with IRS rules. The IRS requires S corporation owners who provide substantial services to pay themselves “reasonable compensation” before taking distributions to prevent tax avoidance.
Determining reasonable compensation involves assessing industry standards, job responsibilities, and company profitability. The IRS considers experience, duties, and comparable salaries in similar businesses. If an owner underpays themselves, the IRS may reclassify distributions as wages, resulting in back taxes, penalties, and interest. For example, if an S corporation owner takes a $20,000 salary while similar roles earn $80,000, the IRS could adjust their compensation and impose payroll tax liabilities.
Salaries also impact tax deductions. Wages paid to employees, including owner-employees, reduce taxable income as deductible business expenses. However, salaries are subject to payroll taxes, including Social Security and Medicare, totaling 15.3%—split between employer and employee. Unlike distributions, salaries carry this additional tax burden.
Function of Distributions
Distributions are payments to business owners from company earnings, typically based on ownership percentage. Unlike salaries, which compensate for work, distributions represent a return on investment. These payments are common in pass-through entities like S corporations and partnerships, where profits flow directly to owners without corporate taxation.
For S corporations, distributions are tax-free as long as they do not exceed the owner’s basis in the company, which includes initial capital contributions, retained earnings, and certain debt obligations. If distributions exceed basis, the excess is taxed as a capital gain. For example, if an owner has a $50,000 basis and receives $60,000 in distributions, the additional $10,000 is subject to capital gains tax, which in 2024 ranges from 0% to 20%, depending on income.
Partnerships follow a similar structure but include guaranteed payments—fixed amounts paid to partners regardless of profitability. These payments are treated as ordinary income and subject to self-employment tax. Regular distributions reduce a partner’s basis and are not taxed unless they exceed it.
Tax Classification Differences
Business structure determines how income is taxed. Sole proprietors and single-member LLCs treat all net earnings as self-employment income, meaning the owner pays both the employer and employee portions of Social Security and Medicare taxes, totaling 15.3% in 2024. Unlike S corporation distributions, there is no separation between wages and profit—everything is taxed as earned income.
Multi-member LLCs and partnerships are different. Partners are not employees and do not receive W-2 wages. Their share of business earnings passes through to their personal tax return, where it is subject to income tax. Unless a partner is a passive investor, these earnings are also subject to self-employment tax. Some entities, such as limited partnerships, allow certain partners to receive distributions without triggering self-employment tax, depending on their involvement.
C corporations follow a different structure. Unlike pass-through entities, C corporations pay corporate income tax on profits before distributing earnings to shareholders as dividends. These dividends are then taxed again at the individual level, creating double taxation. As of 2024, the corporate tax rate is 21%, while qualified dividends are taxed at long-term capital gains rates, ranging from 0% to 20% based on income. Some business owners try to mitigate this by retaining earnings within the corporation, but excessive accumulated earnings—generally above $250,000—may trigger an additional 20% tax under IRS rules.
Ownership vs Employment Distinctions
Owning a business does not automatically make someone an employee. The level of involvement, rather than ownership percentage, determines whether an individual is considered an employee for tax and payroll purposes.
This distinction is particularly relevant in S corporations and C corporations, where shareholders can be passive investors, active employees, or both. Passive owners who do not engage in daily operations are not required to receive wages, as their income comes from dividends or distributions. However, those who contribute significant time and effort must be compensated appropriately under labor laws. Misclassifying an active owner as a non-employee can lead to payroll tax audits, reclassification of income, and penalties.
Avoiding Common Confusions
Many business owners struggle to differentiate between salaries and distributions, leading to tax audits and financial inefficiencies. Misunderstanding how each form of compensation is taxed and how it affects financial reporting can result in unexpected liabilities.
One common mistake is assuming distributions can fully replace a salary in an S corporation. While distributions avoid payroll taxes, the IRS requires owner-employees to receive reasonable compensation for their work. If an owner takes only distributions without a salary, the IRS may reclassify those payments as wages, leading to back taxes, interest, and penalties.
Another issue arises when distributions exceed the owner’s basis in the company, triggering capital gains tax. Business owners should track their basis carefully to avoid unintentional tax consequences.
In partnerships and LLCs, confusion often surrounds self-employment tax obligations. Unlike S corporations, where distributions to shareholders are not subject to self-employment tax, partners in a general partnership or members of an LLC actively involved in the business must pay self-employment taxes on their share of earnings. Some business owners mistakenly believe they can take distributions without tax consequences, only to face additional liabilities when filing returns. Proper planning, structuring compensation appropriately, and maintaining accurate financial records help mitigate these risks.