S Corp Owners Must Pay Reasonable Salary Before Taking Distributions

S corporation owners who draw income from their businesses cannot simply take shareholder distributions and bypass payroll taxes, according to accounting expert David Riggs, who addressed the issue in a recent HelloNation feature. The IRS requires working owners of S corps to first pay themselves a reasonable salary before pulling profits as distributions, a distinction that carries significant tax consequences if ignored.

Determining what qualifies as reasonable compensation is not arbitrary. Riggs explained that relevant factors include the owner's specific duties within the company, professional experience, hours devoted to the business, and what a comparable employer would pay someone performing the same role in the open market. Without a defensible methodology behind the salary figure, owners leave themselves exposed to IRS scrutiny.

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The stakes are higher than many small-business owners realize. Payroll taxes apply to salary but not to distributions, creating a financial incentive to minimize wages and maximize profit draws. The IRS has historically targeted S corps where compensation appears artificially suppressed, and courts have sided with the agency in cases where owners lacked documentation to justify their pay structure.

Riggs emphasized that supporting records are as important as the salary figure itself. Maintaining documentation that captures how a compensation number was reached — including industry surveys, comparable job data, and internal role descriptions — can be the difference between a routine audit and a costly reclassification of distributions as wages, which would trigger back taxes and penalties.

For S corp owners navigating this issue, professional guidance from a qualified accountant or tax advisor is strongly recommended before compensation decisions are finalized. Continue reading at All Financial Services & Investing.