S Corporation Distributions vs. Salary

One of the most consequential tax decisions for an S Corporation owner is figuring out the right balance between salary and distributions. Salary paid to a shareholder who works in the business is subject to payroll taxes, which include Social Security and Medicare taxes owed by both the employer and the employee, while distributions are not subject to those taxes. This difference creates a real financial incentive to keep salaries low and distributions high, but the IRS requires that working shareholders pay themselves a reasonable salary before taking any distributions. If the IRS audits an S Corporation and finds that officer compensation is unreasonably low, it will reclassify a portion of the distributions as wages and assess the unpaid payroll taxes along with interest and penalties. Getting this balance right can save thousands of dollars each year, but it requires thoughtful documentation and an annual review to make sure the salary stays reasonable as the business grows.