If your business is organized as an S‑Corporation, you (as a shareholder‑owner who also works in the business) have a key decision to make each year: how much to pay yourself as W‑2 salary, and how much to take as a distribution. It might be tempting to minimize your salary and maximize distributions for tax savings, but that strategy carries two significant risks.First and foremost: the IRS expects shareholder‑employees who perform meaningful services for the business to receive a “reasonable salary.” Courts have repeatedly held that amounts paid as distributions may be reclassified as wages – meaning back payroll taxes, penalties and interest.
Second, a low salary means you’re under‑paying into Social Security and Medicare, which may reduce future benefits and leave the business vulnerable to employment‑tax reclassification.
Paying yourself a market‑based salary establishes clearer financials for you personally and for the business.
Imagine a construction company generating $1.2 million in revenue. The owner actively manages crews, selects jobs, meets clients and oversees safety and quality. A survey of similar businesses indicates a superintendent/owner role in that region typically earns around $120,000 in wages. If the owner pays only $70,000 salary and then takes $200,000 as a distribution, this creates risk: the IRS may view the extra $130,000 as hidden wages, subject to employment taxes and penalties. But if the owner pays $120,000 salary (market‑based) and takes $100,000 as distribution, then the company is aligned with standards and the owner still receives distribution beyond salary.
In this example the owner might still benefit from a distribution, but only after the salary benchmark is met. Our firm offers a streamlined tool that helps determine market‑based salary ranges for owner‑operators of S‑Corps, allowing you to document your rationale and reduce risk.
Remember that distributions are still tax‑advantageous, but they’re meant to be after salary, not instead of it. Balancing the two, not gaming the system, is key.
Getting your compensation structure right isn’t just about avoiding risk. It also helps your business present clearer financials, supports credible growth planning, and aligns your personal income with what the business truly does.
To review of your compensation approach or to compare it to market benchmarks, contact us at at help@sbsaccountants.com or 770-745-4283.