How to Pay Yourself as an S Corp Owner

An S corporation provides business owners with liability protection and a pass-through tax structure, meaning the business’s profits and losses are reported on the owners’ personal tax returns. This structure avoids the double taxation present with C corporations. For owners who actively work in the business, the Internal Revenue Service (IRS) has specific rules for how they must be paid. To maintain compliance, owner-employees must receive payment through a combination of a formal salary and profit distributions.

Determining Your Reasonable Compensation

The IRS requires that any S corporation owner who provides services to the business must receive “reasonable compensation” in the form of wages before any other payments are made. The reason for this rule is to ensure owner-employees pay their share of employment taxes, including Social Security and Medicare. Without this requirement, owners could classify all their pay as distributions, which are not subject to these taxes.

The IRS does not provide a specific formula for a “reasonable” amount, instead using a facts-and-circumstances test. It looks at multiple factors to determine if the salary is comparable to what a similar business would pay for the same services. Considerations include:

• The owner’s training, qualifications, and experience.
• The duties and responsibilities of the role; for example, a CEO performing high-level strategic work warrants a higher salary than someone doing part-time administrative tasks.
• The time and effort the owner devotes to the business.
• Compensation paid to non-shareholder employees for similar work, which provides an internal benchmark.

To establish a defensible salary, owners should research what comparable businesses in their industry and location pay for similar roles. Resources for this research include the U.S. Bureau of Labor Statistics or private compensation surveys.

Documenting the basis for the salary is a sound practice, such as creating a formal compensation agreement that outlines the duties and salary. While informal guidelines like the “60/40 rule” exist, the IRS does not recognize them. Relying on such a percentage is risky, as the compensation must be justifiable based on the services performed.

Processing Your W-2 Salary

Once a reasonable salary is determined, it must be processed through a formal payroll system. This requires establishing employer accounts, including a Federal Employer Identification Number (EIN) and any necessary state tax and unemployment insurance accounts. Even if you are the sole owner and employee, you must follow these procedural steps for compliance with federal and state laws.

Processing your salary involves calculating and withholding taxes from each paycheck. This includes federal income tax, based on Form W-4, and Federal Insurance Contributions Act (FICA) taxes. FICA taxes consist of a 6.2% Social Security tax on wages up to an annual limit and a 1.45% Medicare tax on all wages, both of which are withheld from the employee’s gross pay.

The S corporation also has employer tax obligations. It must pay a matching amount for FICA taxes, contributing 6.2% for Social Security and 1.45% for Medicare. The business is also responsible for federal (FUTA) and state (SUTA) unemployment taxes. The FUTA tax is 6.0% on the first $7,000 of wages, though credits for SUTA paid can lower the effective rate.

These taxes must be deposited with the IRS on a monthly or semi-weekly schedule, depending on the tax liability, often through the Electronic Federal Tax Payment System (EFTPS). Failure to properly manage payroll taxes can lead to significant penalties. Using a payroll service can help manage these calculations and deadlines.

Taking Shareholder Distributions

After paying a reasonable salary, an S corp owner can receive additional money through shareholder distributions. A distribution is a payment of the company’s profits to shareholders. Unlike salary, distributions are not subject to payroll taxes, which is a primary tax advantage of the S corporation structure.

The taxability of a distribution depends on the shareholder’s stock basis, which measures their economic investment in the company. It begins with the initial capital contribution or stock purchase price. Each year, the basis increases with the shareholder’s share of net income and decreases with distributions received and their share of business losses.

Distributions are a tax-free return of capital as long as they do not exceed the shareholder’s stock basis. If a distribution is larger than the stock basis, the excess amount is treated as a long-term capital gain. It is the shareholder’s responsibility, not the corporation’s, to track their individual stock basis to determine the tax consequences of distributions, which requires meticulous record-keeping.

Annual Tax Reporting Requirements

Operating as an S corporation and paying yourself as an owner-employee creates several annual tax reporting duties that consolidate the year’s activities. For salary paid, the corporation must file Form 941, Employer’s QUARTERLY Federal Tax Return, four times a year. This form reports the income and FICA taxes withheld and paid.

Annually, the corporation files Form 940 to report its FUTA tax liability. By January 31st, it must provide a Form W-2 to each employee, including the owner, detailing wages and taxes withheld. A copy of all W-2s is sent to the Social Security Administration with the summary Form W-3.

The S corporation must file an annual income tax return on Form 1120-S, which reports the company’s income, deductions, and profits. For calendar-year businesses, the filing deadline is March 15th.

Attached to Form 1120-S is a Schedule K-1 for each shareholder, which details their share of the corporation’s income, deductions, and distributions. The shareholder uses their Form W-2 and Schedule K-1 to complete their personal Form 1040. Salary is reported as wages, while the K-1 items are reported on Schedule E.