S Corp Owners Must Set Reasonable Salary Before Taking Distributions

Small business owners operating as S corporations must pay themselves a reasonable salary before taking shareholder distributions, according to accounting expert David Riggs, who addressed the topic in a recent HelloNation feature. The distinction carries significant tax consequences, as salaries are subject to payroll taxes while distributions generally are not.

Riggs explained that the IRS closely monitors compensation decisions made by S corp owner-operators, viewing artificially low salaries as a mechanism to dodge employment taxes. Factors used to determine what qualifies as reasonable compensation include the owner's specific duties, relevant experience, hours devoted to the business, and comparable pay for similar roles in the same industry.

Read more Underinsured Motorist Coverage: What Drivers Need to Know →

Documentation is central to defending any salary figure chosen. Without supporting records — such as written job descriptions, industry wage surveys, or third-party compensation data — S corp owners leave themselves vulnerable to IRS reclassification, which could result in back taxes, penalties, and interest on amounts the agency deems were improperly taken as distributions rather than wages.

The structure offers legitimate tax advantages when managed correctly. Because only the salary portion triggers Social Security and Medicare taxes, a properly justified and documented compensation arrangement can reduce an owner's overall payroll tax burden compared with operating as a sole proprietor or single-member LLC. The key, Riggs emphasized, is that the salary must be defensible, not simply minimal.

For S corp owners uncertain about where to set their compensation, consulting a qualified accountant or tax professional before year-end can prevent costly audits or adjustments. Continue reading at All Financial Services & Investing.