One post tagged with "owner distributions"

If you run an S-corp and work in it, the IRS expects you to take W-2 wages before you take owner distributions. The key phrase that governs this entire process is “reasonable compensation.” Getting this wrong can lead to costly tax adjustments and penalties.

Here’s what “reasonable” means in practice—and how to track it cleanly and defensibly in your Beancount ledger.

What the IRS Actually Requires​

The rules are straightforward: shareholder-employees must be paid reasonable compensation for their services before receiving non-wage distributions. Paying yourself too little (or nothing at all) while taking large distributions is a major red flag. The IRS can, and often does, reclassify those distributions as wages, hitting you with back payroll taxes and penalties.

This isn't a new or obscure rule. The IRS has emphasized it for years, notably in its Fact Sheet FS-2008-25, which clarifies that corporate officers who perform more than minor services are to be treated as employees for FICA tax purposes. On your annual Form 1120-S, officer pay is reported on Line 7 (“Compensation of Officers”), and the instructions explicitly state that these amounts are considered wages to the extent they are for reasonable compensation.

Courts consistently back this up. In the landmark case Watson v. United States, a CPA paid himself a salary of only $24,000 while taking significant distributions from his profitable firm. The court sided with the IRS, recharacterizing most of those distributions as wages subject to employment taxes.

How to Estimate a Reasonable Salary (Simple, Defensible)​

So, how do you determine a "reasonable" number? Think of it this way: what would you have to pay someone else to do the job you actually do, in your market, with your experience? The IRS views this as a valuation problem, and there are several common-sense ways to arrive at a defensible figure.

Here’s a pragmatic workflow:

1. Start with Market Comps: This is your anchor. Use resources like Glassdoor, the Bureau of Labor Statistics (BLS), or salary ranges from recruiters to find data for comparable roles in your geographic area.
2. Factor in Your Role & Time Split: Most small business owners wear multiple hats. Acknowledge this by weighting your salary based on the time you spend on different functions. For example, you might be 60% software engineer and 40% product manager.
3. Perform an Ability-to-Pay Sanity Check: Your company's financial health matters. A business with losses may not be able to support a top-quartile salary. However, reporting zero wages while you perform substantial services is rarely justifiable.
4. Document Everything: Save your sources, notes, and calculations. This documentation is your first line of defense in an audit. (More on this below.)

Quick Worksheet (Illustrative)​

Let's walk through an example:

• Market Pay: You find that the local median salary for a Senior Engineer is $140,000** and for a Product Manager is **$120,000.
• Your Time Split: You estimate your time is 60% engineering and 40% product management.
• Weighted Base Salary: $(0.60 \\times$140,000) + (0.40 \times $120,000) =$84,000 + $48,000 =$132,000$.
• Final Decision: Based on your company's current margins, you decide on a salary of $125,000 and plan to revisit it annually.

For context, the 2025 payroll tax rates are 6.2% for Social Security on wages up to $176,100 and 1.45% for Medicare on all wages. Both the employee and employer pay these amounts.

Common Pitfalls to Avoid​

Steer clear of these common mistakes that can attract IRS scrutiny:

• Taking Distributions Before Wages: If you provided services to your S-corp during the year, you must run payroll for your reasonable wages before taking any distributions.
• Setting a "Token" Salary: A nominal salary—like $10,000 for a full-time officer of a highly profitable company—is a near-certain trigger for reclassification, as seen in the Watson case.
• Mishandling >2% Shareholder Health Insurance: Premiums paid for health insurance for shareholders who own more than 2% of the company must be included in their W-2 wages. These amounts are subject to income tax but are generally exempt from FICA taxes. Coordinate with your CPA or payroll provider to ensure this is handled correctly.

A Clean Beancount Setup​

Your ledger is the perfect tool for maintaining a clear line between wages and distributions.

Minimal Chart of Accounts​

Assets:Bank:Operating
Expenses:Payroll:Wages
Expenses:Payroll:Employer:SocialSecurity
Expenses:Payroll:Employer:Medicare
Liabilities:Payroll:Withholding:Federal
Liabilities:Payroll:Withholding:SocialSecurity
Liabilities:Payroll:Withholding:Medicare
Equity:Distributions

Example Postings​

This example shows a monthly payroll run for a $150,000 annual salary ($12,500/month), followed by a separate owner distribution. Notice how wages are recorded as a business expense, while distributions are a reduction of equity.

; Run monthly payroll (company side + withholdings)
2025-02-28 * "Payroll - February"
  Assets:Bank:Operating                      -10350.00 USD
  Expenses:Payroll:Wages                      12500.00 USD
  Expenses:Payroll:Employer:SocialSecurity      775.00 USD
  Expenses:Payroll:Employer:Medicare            181.25 USD
  Liabilities:Payroll:Withholding:Federal     -3000.00 USD
  Liabilities:Payroll:Withholding:SocialSecurity  -775.00 USD
  Liabilities:Payroll:Withholding:Medicare    -181.25 USD

; Owner distribution (non-wage)
2025-03-10 * "Shareholder distribution"
  Assets:Bank:Operating                      -5000.00 USD
  Equity:Distributions                        5000.00 USD

Useful Checks with bean-query​

Periodically, you should compare your year-to-date wages against distributions. This query makes it easy:

; Compare wages vs. distributions YTD
SELECT account, SUM(position)
WHERE (account ~ "Expenses:Payroll:Wages" OR account ~ "Equity:Distributions")
  AND year = 2025
GROUP BY account;

Paper Trail (Protect Yourself)​

If the IRS ever asks, you'll want your reasoning documented.

• Create a short compensation memo each year. Detail your roles, time split, links to market data you used, and the final salary you chose.
• Store this memo in your Beancount directory, for example: docs/comp/YYYY/comp-memo.md.
• Keep copies of all official payroll reports and your annual W-2/W-3 filings.
• Record your decision directly in your ledger with a note entry.

2025-01-15 note "Set 2025 officer salary at $125,000 based on market comps + role split. See docs/comp/2025/comp-memo.md"

FAQ (Fast)​

• Can my salary be $0 if my company lost money? 📉 If you performed significant services, the IRS still expects you to be paid a reasonable wage for that work. If cash flow is a serious issue, get professional advice on how to proceed.
• How often should I revisit my salary? 🗓️ At least annually. You should also reassess it anytime your role, responsibilities, or the market changes significantly.
• What if I’m the only person in the company? 🙋 Even if you're a solo operator, you are still an employee of your S-corp. You must run formal payroll if you work in the business.

This guide provides general information and is not a substitute for professional tax advice. Always consult with a qualified CPA to address your specific financial situation.