As an S Corporation shareholder, you are considered both a shareholder and an employee. This creates a few nuances that are unique to S Corporations. This is especially true when it comes to S Corporation salaries.
Paying yourself can be very simple if you know what you’re doing. It’s important to make sure you have all of the information you need to set things up properly.
If your business is an S Corporation, here are some important considerations when paying yourself.
S Corporation Salary Considerations
S Corporations are great because you are able to have income from two separate buckets: employee and shareholder. This situation creates a tax-advantage for business owners.
As an employee, federal income taxes, Social Security and Medicare are all withheld from your pay. The business gets a tax deduction for your wages, which is also great.
However, you are also a shareholder. As such, you are able to take distributions from the company. These distributions come from either amounts you contribute to the business or from business profits. These distributions do not incur self-employment taxes (Social Security and Medicare). This results in you saving quite a bit in taxes each year.
Because of this situation, the government wants to make sure that you pay your fair share of self-employment taxes. Since these taxes are only paid on your S Corporation salary, the IRS likes to flag businesses that are not paying reasonable salaries to their shareholders.
How do I make sure my salary is reasonable?
Think about getting a job doing exactly what you do for your business. How much would that pay? Is there an acceptable salary for that position? Do you have an education or critical experience? What roles do you play in the business, and how often do you play those roles?
Answers to all of these questions can help you determine how much you should earn for your employment.
You can always use websites like salary.com or bls.gov to help you determine what other people make in similar jobs. You can also get a formal report documenting your salary number by contacting a CPA or financial adviser. This type of report can be very helpful during an audit because documentation is key.
Whatever you do, try to make sure you have a reasonable basis for the amount you and any other shareholders earn. Also, try to keep any documentation you use in determining the salary number. The more information you have to back it up, the better.
It’s important to note that shareholders can have different salaries. Salaries should be based on work done for the business, not just ownership. That means that two shareholders can have dramatically different salaries with equal shareholder distributions. As long as it’s documented and reasonable, an IRS challenge will be no big deal.
Just keep in mind that if you pay yourself too little, the government won’t be happy. That’s a loss in their tax revenue. If you pay yourself too much, then you might be overpaying your taxes. So you have to find the right midpoint, document it and go with it.
So, you already have income as an employee, but is that all you can take out of the business? That would be a shame wouldn’t it?
Good news! You can definitely take more money out of the business. This is done through distributions (your distributive share).
For example, if there are two equal shareholders in the S Corporation, then each shareholder’s distributive share would be 50% of the business’ profits. If the business’ profits were $100,000, then each shareholder has a distributive share of $50,000. That amount is in addition to your employee salary.
Keep in mind, however, that you have to pay taxes based on your share of profits. The amount you actually take out of the business doesn’t matter.
If, for example, your share of profits for 2018 was $50,000 but you only took out $10,000 in distributions, you would still have to pay federal income taxes on $50,000. So, it does make sense to take distributions since you have to pay taxes on those amounts anyways.
Distribution Best Practices
All distributions should be well-documented and show a clear line between you and the business. On top of that, distributions need to be paid out evenly according to ownership. A lot of problems can arise if you take large distributions and the other shareholder takes very little.
When you take a shareholder distribution, the Board of Directors should just write a check. It doesn’t run through payroll since it’s completely separate. Be sure to include the words “Shareholder Distribution” on the memo line for documentation purposes. This is the most clear cut option. You can also transfer money directly from the business account to your personal account. Just be sure to account for it correctly on your books since this line can be a bit fuzzy.
Summing it up
Once the year is over, you will receive two information documents from the S Corporation.
- a K-1 that shows all of your dealings with the company and your share of profits; and
- a W-2 that shows your employee wages and all taxes withheld.
Both of these documents must be included on your personal tax return to show your shareholder-employee status.
Remember, for your employee salary, the business will withhold your federal income taxes, Social Security and Medicare. For your distributive share, you are responsible for paying federal income taxes.
You can download two flowcharts below showing how income and taxes work as an employee and shareholder.
To learn more about paying your taxes as an S Corp, check out my blog post on S Corporation taxes.
Note: This blog post is meant for educational and informational purposes only. Please contact a tax or accounting professional if you have specific questions about what this means for your business before taking any further action.