What Is an S Corp?
An S corporation is a tax designation used by LLCs and corporations. It may prove advantageous because S corps status can potentially save business owners money on their taxes.
The IRS considers members and owners of an LLC or corporation employees of an S corp who must receive a reasonable salary for any work they perform for the organization. After an S corp pays these reasonable salaries, its members can then collect distributions.
S corp owners receive compensation in two ways:
- Reasonable Salaries: This is the money S corp owners pay themselves through the company. The IRS considers it a wage so it’s subject to income tax and self-employment tax, which covers Social Security and Medicare taxes.
- Distributions: These profits and losses, which pass through an S corp to its members, are only subject to income tax — not employment taxes.
S Corp Reasonable Salaries
The IRS requires S corp owners to pay themselves a reasonable salary before they can take distributions. While the definition of a reasonable salary is intentionally vague because it can vary by industry and role, “reasonable” generally means paying yourself a wage you’d pay someone else to perform the same job.
S Corp Distributions
While S corp distributions do offer shareholders the potential to save money on their taxes, they’re still subject to income tax.
What Are Distributions?
As previously noted, distributions are the profits and losses accrued by a company that it then passes on to its shareholders at a lower tax rate. They offer shareholders a way of withdrawing profits from their company separate from their wages.
S corps must allocate distributions to shareholders based on their ownership percentage as determined by either their purchase of shares or the company’s Operating Agreement. Here are some other key facts about distributions:
- You don’t have to take a distribution from your S corp.
- You can choose to take neither a distribution nor a reasonable salary. (But, if you wish to take distributions in the future, you must pay yourself reasonable compensation for the services you provide in the years before you take a distribution.)
S Corp Distribution Tax Rate
Your reasonable salary is subject to both payroll and income taxes. Payroll taxes are a 15% tax that covers your contributions to Social Security and Medicare. While you must still pay income taxes on your distributions, you don’t have to pay payroll taxes because the IRS considers distributions as profits — not wages. This makes it advantageous to take as much in distributions as possible to save money on your taxes.
However, taking distributions can lead to increased scrutiny from the IRS. Members of an S corp may feel incentivized to pay themselves a lower salary in order to take larger distributions. But, failure to pay reasonable compensation can result in back taxes and penalties as well as distributions being subject to payroll tax.
How Much Should I Take in S Corp Distributions?
While there’s no set rule for how much money a business owner should take in distributions, an S corp must allocate distributions to shareholders proportionally by their ownership stake. S corp distribution tax rates also incentivize you to take as much money as you can in distributions. But, regardless of your compensation strategy, make sure to follow IRS guidelines and adjust your strategy as your business grows.
Prioritize Your Reasonable Salary First
An S corp must meet the IRS’s reasonable salary requirement before it can pay distributions to its owners. If your S corp doesn’t have enough money to pay you a reasonable salary, you can’t take distributions.
The 60/40 Rule
As with reasonable compensation, the IRS doesn’t provide guidelines for how much you should take out in distributions. For this reason, S corps often follow the “60/40 Rule” when issuing distributions. This rule guides S corps to pay 60% of their revenue as salaries and the other 40% as distributions.
Ultimately, this is an arbitrary rule and not one you can use to justify your salary-to-distribution ratio to the IRS.
Reporting S Corp Distributions
You must report any distributions you receive from your S corp on your annual tax return. You do this by filing:
- Schedule K-1: This form lists what each shareholder made in profits or losses for a given tax year. If you take distributions, you must report them on your personal tax return (Form 1040).
- Form W-2 - Wage and Tax Statement: This form reports an employee's income and all taxes withheld from their wages.
- Form 1040 - US Individual Income Tax Return: This is the form you use to file your personal income taxes. To complete this form, you’ll need to:
- Use information from your Form W-2 to report your S corp salary.
- Use Schedule E to report and pay personal income taxes on distributions.
Additionally, the S corp will file:
- Form 1120S - US Income Tax Return for an S Corporation: This form reports on the business’s income, gains, losses, tax credits, and tax deductions.
S Corp Distribution Examples
Now that we’ve discussed the benefits of taking distributions from your S corp, here are two examples of what that might look like in a real world scenario.
Example 1: Let’s say you’re a member of a digital design S corp in Austin, Texas, and you have a 40% share in your company. There are three other members who each have a 20% share in the company. Your S corp has an annual net profit of $500,000 and, after paying your four members each a reasonable salary of $76,000, you have around $196,000 in profits left in distributions. The three members who own 20% will each receive $39,200 in distributions while you’ll receive $78,400 given your 40% ownership stake.
Example 2: Let's now assume you’re the sole member of a marketing S corp in San Francisco and your annual net profit of $90,000. Research shows that the reasonable salary for a marketing manager in your area is about $110,000 per year. For this reason, you can’t pay yourself a reasonable salary and you don’t take any distributions.
S Corporation Distributions Key Takeaways
S corp status allows owners of growing and small businesses to enjoy the net profits of their company at a lower tax rate while still paying themselves a reasonable salary. While they do require heightened diligence when filing taxes, the potential tax savings and advantages of taking distributions are well worth the effort.
Ready to learn more about S corps? Visit our What Is an S Corporation guide to learn more and decide if an S corp is right for your business.