S Corp Owners Must Set Reasonable Salary Before Taking Distributions

Business owners operating as S corporations cannot simply take distributions without first paying themselves a reasonable salary, according to accounting expert David Riggs, who addressed the issue in a recent HelloNation feature. The distinction carries significant payroll tax consequences, making compensation decisions one of the most consequential choices an S corp owner can make.

The IRS requires working shareholders to receive compensation that reflects what a comparable employee would earn for similar duties. Factors used to determine that figure include the owner's specific responsibilities, professional experience, hours devoted to the business, and prevailing wages for equivalent roles in the same industry. Without adequate documentation supporting the salary chosen, owners risk reclassification of distributions as wages — triggering back payroll taxes, penalties, and interest.

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Riggs emphasized that record-keeping is not optional. Supporting records that justify a compensation decision serve as a first line of defense should the IRS challenge the arrangement. Industry surveys, written job descriptions, and contemporaneous notes on hours worked all strengthen an owner's position during an audit.

The separation between salary and distributions is not merely a compliance formality. Payroll taxes, including Social Security and Medicare contributions, apply to wages but not to shareholder distributions. That structural difference creates a legitimate tax-planning opportunity for S corp owners — but only when the underlying salary is defensible and well-documented. Aggressive undercompensation has consistently drawn IRS enforcement attention.

For S corporation owners navigating these rules, professional guidance is strongly recommended before setting or adjusting compensation levels. Continue reading at All Financial Services & Investing.