An S-Corp is often touted as one of the most efficient business structures for minimizing taxes for business owners.
It’s a common practice for S Corp owners to take tax-favored distributions of their proportional share of the profits in lieu of paying themselves a higher W-2 wage. Taking this approach allows them to avoid paying payroll tax on the distributions.
For this reason, the IRS scrutinizes S-Corps more closely.
The IRS mandates that an S-Corp owner be paid a “reasonable wage.” The trouble is, a reasonable wage is subjective because business owners wear many hats – sales, marketing, fulfillment, etc. Given that, a reasonable wage can be hard to pin down, and the advice varies depending on the source.
In this article, we’ll examine S-Corp owner compensation options, the tax implications, and share guidance on how you might use the “reasonable wage” requirement to your advantage within the IRS guidelines.
Distributions vs Salary: How S-Corp Pay Works For Owners/Shareholders
Within an S-Corp, you typically have the owners, shareholders, and corporate officers who each play a role in the business. Owners and Shareholders of S Corporations receive income in two ways. Each is taxed differently as noted below:
- Salary: Monetary compensation paid for a service, either to yourself or a corporate officer, usually for a fixed sum for a specified period of time worked. As we’ll examine later, this pay must be “reasonable,” however, the trouble is that the IRS does not outline what “reasonable” means in specific terms. We’ll explore this in greater detail later on.
- Distributions: This represents your share of the profits of the S-Corp.Distributions are not part of your employee wages and are not subject to self-employment tax.
You can learn more in this IRS guide to wage compensation for S-Corp officers.
A reasonable salary is a deductible expense to the S corp and will be subject to payroll taxes, while distributions are non-deductible and not subject to employment taxes. That’s because distributions are pass-through allocations of profit.
This, in a nutshell, is the benefit of being taxed as an S-Corp: you can pay yourself distributions and not pay self-employment taxes on them, resulting in an immediate 15.3% total tax savings.
As a result, the IRS closely monitors S-Corps to prevent shareholders from misclassifying income as distributions to avoid payroll taxes. This applies even if you’re the sole owner and sole employee – in fact, single-owner S-Corps face the highest scrutiny.
How an S-Corp Owner Pays Taxes
Unlike a C-Corp, an S-Corp does not directly pay taxes.
A chief advantage of the S Corporation entity structure is that it is not subject to corporate-level taxation. S-Corps are known as pass-through entities, which means profits and losses flow to the shareholders’ personal tax return via Schedule K-1 of the 1120-S Tax Return for an S Corporation.
Shareholders must receive a reasonable W-2 wage, and are responsible for:
- Income tax (wages and distributions)
- Payroll tax (15.3% split between the business and employee), which applies only to income and not to distributions.
There is some fine print on payroll taxes, as the Social Security tax is capped at $176.100 of wages (2025), indexed for inflation, and the Medicare tax has no wage cap and in fact increases at certain income levels based on filing status ($250,000 in 20025 for married filing jointly).
The ability to avoid taxation at the entity level and receive distributions without paying payroll taxes can provide significant self-employment tax savings compared to sole proprietorships or partnerships. Learn more about S-Corp taxation rules and requirements here.
S-Corp Owner Taxation Scenarios
Now you probably see the benefits here. Suppose your S-Corp made $500,000 in profit last year. Could you pay yourself $100,000 and receive $400,000 in distributions?
Let’s look at how you would be taxed in three different scenarios.
Scenario 1: Pay Yourself a W-2 Salary of $100,000
If you paid yourself a W-2 salary of $100,000 and pocketed $400,000 in distributions, you could expect the following:
- Social Security Tax- Employee 6.2% or $6,200
- Medicare Tax-Employee 1.45% or $1,450
- Social Security Tax-S Corp 6.2% or $6,200
- Medicare Tax-S Corp 1.45% $1,450
So the total tax paid between the business and you is $15,300.
Scenario 2: Pay Yourself a W-2 Salary of $175,000
If you paid yourself a W-2 salary of $175,000 and pocketed $325,000 in distributions, you could expect the following:
- Social Security Tax- Employee 6.2% or $10,850
- Medicare Tax-Employee 1.45% or $2,537.50
- Social Security Tax-S Corp 6.2% or $10.850
- Medicare Tax-S Corp 1.45% $2,537.50
So the total tax paid between the business and you is $26,775.
Scenario 3: Pay Yourself a W-2 Salary of $250,000
If you were to pay yourself $250,000 in W-2 wages and $250,000 in distributions, you could expect the following:
- Social Security Tax- Employee 6.2% or $10,850
- Medicare Tax-Employee 1.45% or $3,625
- Social Security Tax-S Corp 6.2% or $10.850
- Medicare Tax-S Corp 1.45% $3,625
So the total tax paid between the business and you is $28,950. That’s around $13,000 more in taxes than if you took a $100,000 W-2 salary.
Considering these examples, there are significant tax savings if you can establish a lower reasonable wage for IRS purposes. This is where the IRS guidelines around a “reasonable wage” come into play.
Why Does a Reasonable Wage Matter?
The IRS is well aware of how attractive S-Corps are to small business owners. The thought of paying less in taxes than with an LLC or a sole proprietorship is enough to consider choosing an S Corporation when starting a new business. That is why S corporations have been a very popular entity structure.
As a result, the IRS goes to great lengths to identify those who might “game” the system. The IRS has the authority to reclassify distributions as wages, putting you in the uncomfortable position of owing employment taxes and interest.
As with all things under the IRS, it’s best not to tempt fate. Instead, there are ways within the IRS guidelines you can strategically position yourself and your business without having to worry about being out of compliance.
IRS Guidelines Around Reasonable S-Corp Pay
As noted above, there is no explicit IRS guidance on what constitutes reasonable compensation. Over the years, various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case. There is no consistent model, so setting a reasonable wage can involve several variables.
A safe bet might be the market-rate W-2 salary you would pay someone else to perform the same services you provide to your business, or to a third party for similar services. However, small business owners “wear a lot of hats,” so how do you account for all of the different roles?
The IRS may consider the following variables to determine the reasonable pay:
- Geography
- Company size
- Industry
- Time devoted
- Company profitability
- Distribution history
Some professionals reference a “60/40” salary/distribution rule, but the IRS looks at market-rate compensation for your role, industry, size, and geography. Treat ratios only as very rough conversation starters, and not hard and fast rules. Each case should stand on its own merit, given the circumstances.
How to Calculate Your Reasonable Wage
Determining a reasonable wage isn’t a matter of guesswork.
The IRS expects you to use objective inputs to support the salary you choose. While the IRS doesn’t publish a formula, tax professionals rely on three accepted approaches to calculate reasonable compensation.
- A market-based approach: Look up salary data for a comparable role using public data from the Bureau of Labor Statistics or websites like Glassdoor or Payscale.
- A time-based approach: Consider the time you spend in your business and the hourly rate you would pay for that time. This can be useful if you wear many hats in the business.
- A cost-to-replace approach: Consider what it would cost to hire someone to do the work that you do. While not always perfect, that can be a good starting point for assessing what your compensation should be.
As you can see, there’s a fair bit of nuance here. It helps to err on the side of caution. Still, there’s no substitute for speaking with a qualified tax professional to ensure that you are staying compliant while acting as strategically as possible.
Are You Paying Yourself as Strategically as Possible? Find Out With a Free Assessment
Have you set up your finances as strategically as possible?
Most business owners we speak to know they’re paying too much in taxes, but they don’t realize there are simple strategies within the IRS Code to reduce taxes by thousands of dollars.
For S Corporation owners, reducing your W-2 income to a reasonable wage could easily save $10,000 or more. This is just one small example of the strategies you should be implementing in your business. All you need is a strategic approach to your business and compensation.
That means taking a look at your:
- Compensation
- Exit strategy
- Charitable giving
- Investment strategy
- Retirement saving
If you’re overpaying on your taxes, it’s not because your CPA is withholding information from you – it’s because your CPA is focused on filing your forms correctly rather than thinking strategically about your financial plan.
That’s why we’re offering a no-cost evaluation to assess your tax situation. We partner with the best tax advisory firms across the country who can identify your best areas of opportunity in as little as a free 45-minute call.
Fill out a form here to see how you can retain more of your earnings and grow your wealth.
All of the above tax information is for information purposes only and is provided to explain the basic tax treatment based on the Internal Revenue Code. Any individual or entity considering any tax strategies should consult with their own CPA or tax/legal advisor who understands their particular tax circumstances and the rules governing their state. In no way is this information intended to be tax or legal advice.
