The S-corp's tax advantage lives in one split: salary vs. distributions. Salary is subject to payroll taxes (15.3% combined up to the Social Security wage base); distributions are not. Get the split right and you save real money. Get it wrong and you invite the IRS's most common S-corp audit issue.
The rule: reasonable compensation first
If you work in your business, the IRS requires a "reasonable" W-2 salary before you take distributions. Reasonable means roughly what you'd pay someone else to do your job. Factors that matter: your role and hours, your training and experience, what comparable businesses pay, and the company's size and revenue.
How to set the number
- Price the role, not the profit. Look at market data for the actual jobs you do (operator, rainmaker, technician) in your region.
- Document it. A one-page memo with comparables, revisited annually, converts an argument into a defensible position.
- Scale with reality. A $150K-profit firm paying a $40K salary raises eyebrows; the same salary at a $60K-profit startup year may be perfectly defensible.
The math, illustrated
Say the business nets $200K. At a $90K reasonable salary, roughly $110K flows as distributions free of the ~15.3% payroll tax — saving roughly $12–14K per year versus taking it all as salary (numbers vary with the wage base and your situation). That's the engine; reasonable compensation is the governor on it.
Execution details that get missed
- Run real payroll — W-2, withholding, quarterly filings. "I'll 1099 myself" is not an option for S-corp owners.
- Health insurance: premiums for a 2%+ shareholder must be added to W-2 wages (then deducted personally). Most payroll errors we fix start here.
- Retirement leverage: employer 401(k) contributions are calculated on W-2 wages — a salary set too low also caps your retirement deduction.
- Basis and proportionality: distributions beyond your stock basis become taxable, and multi-owner S-corps must distribute in proportion to ownership.
Lemoti reviews owner compensation annually as part of tax planning — salary study, payroll setup, and the quarterly projections that keep the whole structure working.