How to Pay Yourself From an S Corp

You Are Both an Owner and an Employee

An S corporation is a pass-through entity, so the business itself pays no federal income tax. Profit flows to shareholders on a Schedule K-1 and is reported on their personal returns. What makes an S corp different from a sole proprietorship is that a shareholder who performs services for the business is also an employee of it, and the IRS expects that work to be paid as wages before any profit is distributed.

• Wages are paid to you as an employee, through payroll, and reported on a W-2
• Distributions are paid to you as a shareholder, and are not run through payroll
• Profit is reported to you on Schedule K-1 whether or not it is distributed
• A shareholder who performs no services for the business is not required to take a salary

The Two Ways Money Reaches You

Salary and distributions are taxed differently, and that difference is the entire reason the S corp structure is popular with owner-operators. Wages carry employment tax. Distributions do not. That does not make distributions free money, because the underlying profit is still subject to income tax on your personal return, but it does mean the split between the two matters.

• Salary: subject to Social Security (6.2% employee plus 6.2% employer), Medicare (1.45% each side), and federal and state income tax withholding
• Distributions: not subject to Social Security or Medicare tax
• Both are ultimately subject to federal income tax, salary through withholding and profit through your personal return
• Distributions beyond your basis in the company become taxable gain, so basis has to be tracked

Reasonable Compensation Comes First

The IRS requires that a shareholder-employee be paid reasonable compensation for the services actually performed before non-wage distributions are made. This is the central rule of S corp owner pay and the one most often ignored. Paying yourself a token salary and taking the rest as distributions is the pattern the IRS looks for, and it has the authority to reclassify those distributions as wages, then assess back employment taxes, penalties, and interest.

• There is no statutory formula and no safe harbor percentage
• The standard is what you would have to pay someone else to do the same work
• The determination is fact-specific, which is why it is worth documenting your reasoning
• Rules of thumb such as a 60/40 salary-to-distribution split appear nowhere in the tax code

The Payroll You Have to Run

Once you decide on a salary, you have to actually run payroll on yourself, even if you are the only person in the company. That means withholding tax from your own paycheck, depositing it to the IRS on a schedule, and producing the same paperwork any employer produces. Many owners are surprised by how much administration a one-person payroll carries.

• Complete a Form W-4 for yourself, the same as any employee would
• Calculate withholding each pay period and produce a pay stub showing the itemized amounts
• Deposit withheld income tax and both halves of FICA through EFTPS on your assigned schedule
• File Form 941 each quarter, or Form 944 annually if the IRS has notified you that you qualify
• File Form 940 annually for federal unemployment tax; shareholder-employee wages are subject to FUTA
• Issue yourself a W-2 by January 31 and transmit a W-3 to the Social Security Administration
• Register for state withholding and state unemployment insurance, which have their own filings

Health Insurance Is Handled Differently

If the corporation pays health insurance premiums for a shareholder who owns more than 2% of the company, those premiums have to be added to the wages reported in Box 1 of your W-2. They are not subject to Social Security and Medicare tax when paid under a plan established by the business, and you then claim the self-employed health insurance deduction on your personal return. Getting this wrong is one of the most common errors in one-person S corp payroll.

• Premiums are included in W-2 Box 1 wages but excluded from Social Security and Medicare wages
• The plan must be established by the business for this treatment to apply
• You deduct the premiums as an adjustment to income on your Form 1040
• The amount has to be recorded before the final payroll of the year so the W-2 is correct

Common Mistakes

Most S corp owner pay problems come from treating the company account as a personal account, or from setting up payroll late in the year and trying to backfill. Both create work that is far more expensive than doing it correctly from the start.

• Taking draws all year and running a single large payroll in December to catch up
• Setting salary at an amount chosen to minimize tax rather than to reflect the work performed
• Forgetting that a very low salary also caps retirement plan contributions, which are based on W-2 wages
• Missing state registration, which carries its own penalties separate from the federal ones
• Failing to keep year-to-date totals, which makes the W-2 hard to reconcile at year end

When to Bring in Help

The mechanical parts of one-person payroll are manageable on your own. The judgment call about reasonable compensation is not, and it is the part with real exposure attached. A CPA who works with small S corps can help you land on a defensible number and document how you arrived at it. This guide is general information, not tax advice for your specific situation.