How to Pay Yourself From an S Corp: A Complete Guide to Owner Compensation
What if you could cut your tax bill by $10,000 or more each year just by changing how you pay yourself? That's exactly what S corporation owners discover when they master the art of splitting income between salary and distributions. But get it wrong, and you could face IRS penalties, back taxes, and interest that wipe out any savings.
The challenge lies in navigating the IRS's "reasonable compensation" requirement while maximizing your tax advantages. This guide walks you through everything you need to know about paying yourself from an S corp, from setting the right salary to avoiding costly audit triggers.
Why S Corp Compensation Matters
The primary advantage of an S corporation structure comes down to how income flows to owners through two distinct channels: salary and distributions. Each has very different tax treatment, and understanding this difference is key to optimizing your compensation strategy.
Salary vs. Distribution Tax Treatment
When you pay yourself a salary, that income is subject to the full 15.3% payroll tax (12.4% Social Security plus 2.9% Medicare). Both you and your S corp pay half of this amount.
Distributions, however, escape payroll taxes entirely. They're only subject to income tax at your individual rate. This is why the S corp structure appeals to business owners who earn more than they need to pay themselves in salary.
The Real-World Tax Savings
Consider a business owner with $120,000 in S corp profits. As a sole proprietor, they'd owe approximately $18,360 in self-employment tax on the entire amount.
As an S corp owner paying themselves a reasonable salary of $75,000, only that salary portion faces payroll tax (approximately $11,475). The remaining $45,000 taken as distributions avoids payroll taxes entirely, saving roughly $6,885 per year.
For higher earners, the savings grow even more substantial. A business owner with $200,000 in income who pays a $95,000 salary and takes $105,000 in distributions could save over $16,000 in self-employment taxes annually.
The Reasonable Compensation Requirement
Here's where many S corp owners get into trouble: the IRS doesn't let you pay yourself zero salary to avoid employment taxes. You must pay yourself a "reasonable salary" before taking any distributions.
What the IRS Considers "Reasonable"
The IRS defines reasonable compensation as "an amount that would ordinarily be paid for like services by like organizations in like circumstances." To determine this, they look at:
- Your training, education, and professional qualifications
- Years of experience in your field
- Duties, responsibilities, and time commitment
- Comparable salaries in your industry and geographic area
- The size and complexity of your business
- Your company's dividend history
- Compensation paid to non-shareholder employees
Resources for Benchmarking Your Salary
Several reliable sources can help you establish a defensible salary figure:
- Bureau of Labor Statistics (BLS) - Free government data on occupational wages by location
- Glassdoor and LinkedIn Salary - Crowdsourced compensation data
- PayScale - Industry-specific salary benchmarks
- Robert Half Salary Guides - Detailed compensation surveys by profession
- Industry associations - Many publish annual compensation surveys
The 60/40 Rule Myth
You may have heard that paying 60% as salary and 40% as distributions is a safe ratio. This is a myth. The IRS doesn't recognize any percentage-based formula. Your compensation must be based on market standards and your specific business circumstances, not arbitrary ratios.
Setting Up S Corp Payroll
Even if you're the only employee, you must establish a formal payroll system for your S corporation.
Essential Payroll Components
Your S corp payroll system must handle:
- Federal income tax withholding based on your W-4 elections
- Social Security tax (6.2% employee portion, 6.2% employer portion, up to the wage base)
- Medicare tax (1.45% each for employee and employer, plus 0.9% additional Medicare tax on wages over $200,000)
- State income tax withholding if applicable
- State unemployment insurance
Required Tax Forms and Deadlines
Form 941 (Quarterly): Reports federal income tax withheld, Social Security tax, and Medicare tax. Due April 30, July 31, October 31, and January 31.
Form 940 (Annual): Reports federal unemployment tax (FUTA). Due January 31.
Form W-2 (Annual): Reports total wages and tax withholdings to each employee. Due to employees by January 31.
Form W-3 (Annual): Transmittal form accompanying W-2s to the Social Security Administration. Due January 31.
If your annual payroll tax liability is $1,000 or less, you may qualify to file Form 944 annually instead of quarterly Form 941s.
Payroll Service Options
Most S corp owners use one of these approaches:
- Full-service payroll providers (Gusto, ADP, Paychex) - Handle all filings and payments for a monthly fee
- Accounting software with payroll (QuickBooks, FreshBooks) - Integrated solutions for bookkeeping and payroll
- DIY payroll - Calculate and file yourself (risky without payroll expertise)
For most single-owner S corps, a basic payroll service costs $30-50 per month and eliminates the risk of filing errors or missed deadlines.
The Distribution Process
Once you've paid yourself a reasonable salary and met all payroll obligations, remaining profits can be distributed to shareholders.
How Distributions Work
Distributions represent your share of company earnings paid out to you as a shareholder. Unlike dividends from C corporations, S corp distributions generally aren't taxed twice. The income is taxed once on your personal return, and distributions themselves are typically tax-free up to your stock basis.
Stock Basis Explained
Your stock basis represents your investment in the S corporation. It starts with your initial capital contribution and adjusts over time based on income, losses, and distributions.
You don't pay tax on distributions until they exceed your stock basis. Once you've distributed more than your basis, the excess is taxed as capital gains.
Taking Distributions Correctly
To properly take an S corp distribution:
- Ensure reasonable salary has been paid
- Verify all payroll taxes are current
- Confirm sufficient retained earnings exist
- Write a check or transfer from the business account to your personal account
- Record the distribution in your accounting records as an equity reduction
Health Insurance Deduction for S Corp Owners
If you own more than 2% of your S corporation, special rules apply to health insurance.
The 2% Shareholder Rule
A "2% shareholder" is anyone owning more than 2% of the company's stock or voting power. Health insurance premiums paid for 2% shareholders receive unique tax treatment.
How to Structure the Deduction
For the S corp to deduct health insurance premiums for a 2% shareholder:
- The S corp pays the premiums (or reimburses you for premiums you paid)
- The premium amount is added to your W-2 wages (Box 1)
- The premiums are excluded from Boxes 3 and 5 (no FICA taxes)
- You claim the self-employed health insurance deduction on your personal return
This structure lets you deduct health insurance premiums without paying payroll taxes on them.
Important Limitations
You cannot take this deduction if you or your spouse was eligible for employer-subsidized health coverage during any month of the tax year. Additionally, the deduction cannot exceed your earned income from the S corporation.
2025-2026 Key Numbers
Stay current on these important thresholds:
- Social Security wage base (2025): $176,100
- Maximum Social Security tax (2025): $10,918.20 per person
- Additional Medicare Tax threshold: $200,000 (single), $250,000 (married filing jointly)
- QBI deduction: 20% of qualified business income (made permanent in 2025)
- QBI phase-out (2025): Begins at $191,950 for single filers
- HSA contribution limits (2025): $4,300 (self-only), $8,550 (family)
The Qualified Business Income Deduction
The 20% Qualified Business Income (QBI) deduction adds another layer to S corp compensation planning. This deduction applies to your share of S corp income, but only the distribution portion, not your W-2 wages.
This creates an interesting trade-off: a higher salary means more payroll tax but a lower QBI deduction base. The optimal balance depends on your total income, filing status, and other factors.
For most S corp owners, the self-employment tax savings from lower salaries outweigh the reduced QBI benefit. However, consult with a tax professional to model your specific situation.
Common Mistakes to Avoid
Taking No Salary or Too Little Salary
The IRS actively pursues S corp owners who pay themselves unreasonably low salaries. They can reclassify distributions as wages, assess back payroll taxes plus interest, and impose penalties reaching 20% or more.
Inconsistent Compensation Practices
Paying yourself sporadically or changing your salary dramatically year to year raises red flags. Establish a consistent payment schedule that reflects your ongoing work for the company.
Failing to Document Your Rationale
If audited, you'll need to demonstrate how you arrived at your salary figure. Keep copies of salary surveys, job descriptions, board minutes documenting compensation decisions, and any other supporting documentation.
Missing Payroll Deadlines
Late payroll tax deposits trigger penalties from 2% to 15% depending on how many days late. Missed quarterly filings add 5% per month up to 25%. Use automated payroll services to avoid these costly mistakes.
Getting Your Compensation Right
Successfully paying yourself from an S corp requires balancing several factors:
- Set a defensible reasonable salary based on market data and your role
- Establish proper payroll systems with timely deposits and filings
- Take distributions only after salary and payroll obligations are met
- Document everything to support your compensation decisions
- Review annually as your business and the tax laws change
Consider working with a CPA experienced in S corporation taxation to optimize your compensation structure and ensure compliance.
Track Your S Corp Finances with Precision
Managing S corp compensation requires meticulous record-keeping. Between salary payments, distributions, stock basis tracking, and quarterly tax deposits, the financial complexity adds up quickly.
Beancount.io offers plain-text accounting that gives S corp owners complete transparency over every transaction. Track owner compensation, distributions, and equity changes in a format that's version-controlled, auditable, and ready for tax time. Get started for free and bring clarity to your S corp finances.
