As an S corporation owner, you can compensate yourself through a combination of salary and distributions. Understanding the distinctions between these two forms of compensation is crucial for tax compliance and optimization.
1. Salary (W-2 Wages):
- Definition: A reasonable compensation paid to you as an employee of the S corporation for the services you provide.
- Tax Treatment: Subject to federal income tax withholding, Social Security and Medicare taxes (collectively known as FICA), and federal unemployment taxes.
- IRS Requirement: The IRS mandates that S corporation owners who are actively involved in the business pay themselves a "reasonable" salary. Failure to do so can lead to reclassification of distributions as wages, resulting in back taxes and penalties.
2. Distributions:
- Definition: Profits distributed to you as a shareholder, representing a return on your investment in the corporation.
- Tax Treatment: Generally not subject to FICA taxes, but included in your taxable income.
Key Considerations:
- Reasonable Compensation: The IRS provides guidelines but no specific formula, making thorough documentation essential. Use our reasonable compensation calculator to help you determine your reasonable compensation.
- Balancing Salary and Distributions: While paying a lower salary and higher distributions can reduce payroll taxes, setting an unreasonably low salary increases the risk of IRS scrutiny.
- Tax Reporting: Salaries are reported on Form W-2 and are deductible expenses for the corporation. Distributions are reported on Schedule K-1 and are not deductible by the corporation.
In summary, as an S corporation owner, it's essential to pay yourself a reasonable salary commensurate with your role and industry standards. After establishing this salary, additional profits can be distributed as shareholder distributions, potentially offering tax advantages. However, careful consideration and documentation are vital to ensure compliance with IRS regulations.
