S Corp Salary vs Distributions

How Each Is Taxed

Both salary and distributed profit end up subject to federal income tax on your personal return. The difference is employment tax, which applies to wages and not to distributions. That single distinction drives the entire strategy.

• Salary is subject to Social Security at 6.2% from you and 6.2% from the company, up to the annual wage base
• Salary is subject to Medicare at 1.45% from each side with no cap, plus 0.9% more on employee wages over $200,000
• Salary is subject to federal and state income tax withholding at the time it is paid
• Distributions carry no Social Security or Medicare tax
• Profit is taxed to you on your personal return whether or not it is actually distributed

A Worked Example

Consider an owner-operator characterizing $150,000 of business earnings, where the owner performs all the work. The comparison below isolates the employment tax difference and ignores income tax, which is broadly similar either way because both routes reach your personal return.

• All $150,000 as salary: Social Security at 12.4% across both sides is $18,600, Medicare at 2.9% is $4,350, for $22,950 in combined employment tax
• Salary of $90,000 plus $60,000 in distributions: the same rates apply only to the $90,000, for $13,770
• The difference of $9,180 is the actual benefit of the structure in this scenario
• That benefit only holds if $90,000 is genuinely reasonable pay for the work performed
• Figures are illustrative. They ignore state taxes, the deductibility of the employer share, and your specific facts

What Stops You From Taking It All as Distributions

If distributions avoid employment tax entirely, the obvious question is why not set salary near zero. Several constraints prevent it, and only the first is about audit risk.

• Reasonable compensation is required first; the IRS can reclassify distributions as wages with penalties and interest
• Distributions in excess of your basis in the company become taxable gain
• Retirement plan contributions are based on W-2 wages, so a low salary caps what you can put away
• Social Security benefits are calculated from reported wages, so understating salary reduces your eventual benefit
• Some lenders size borrowing against W-2 income, which a minimal salary limits

Basis and Distribution Timing

Distributions are tax-free only to the extent of your stock basis, which increases with income allocated to you and decreases with losses and distributions taken. Tracking basis is your responsibility as the shareholder, not the corporation's, and it is a common gap in one-person S corps.

• Basis starts with what you contributed and adjusts each year
• Allocated income increases basis; losses and distributions decrease it
• A distribution beyond basis is treated as gain from the sale of stock
• Keep a running basis schedule each year rather than reconstructing it later

Health Insurance and Retirement Interact With the Split

Two items commonly change the calculus in ways that are easy to miss when the salary number is chosen purely to minimize employment tax.

• Premiums the company pays for a more than 2% shareholder are added to W-2 Box 1 but excluded from Social Security and Medicare wages
• A solo 401(k) allows an employee deferral plus an employer contribution calculated as a percentage of W-2 wages
• Setting salary too low can cost more in lost retirement contribution room than it saves in employment tax
• The qualified business income deduction also interacts with wages paid, which is worth raising with your accountant

The Judgment Call Is Not a Calculation

The arithmetic above is straightforward once a salary is chosen. Choosing it is not, because reasonable compensation is a facts and circumstances determination rather than a formula. Treat this guide as background on how the pieces fit together and work the actual number out with a tax professional who knows your business.