Earnings Reasonable salary
- Paid as
- Wages, through a regular payroll
- Set by
- What the work would cost to hire someone else to do
- Payroll taxes
- Social Security and Medicare, withheld and matched
- Income tax
- Withheld from each paycheck, reported on a W-2
S corporation taxes, itemised
How S corporation taxes work, from reasonable salary to state tax
An owner who works in an S corporation is paid two ways, and the tax code treats each one differently.
Distributions Profit paid out
- Paid as
- A share of profit, in proportion to ownership
- Set by
- What the business has earned and the owner has left in it
- Payroll taxes
- None withheld
- Income tax
- Reported on the owner’s return through the Schedule K-1
Memo How S corporation taxes work: reasonable salary, distributions, self-employment tax, payroll obligations and the state taxes that apply on top. Every value on this statement is written in words: the split between the two columns follows from the work the owner does, and the rules on each side are what this guide sets out.
Before the statement
What the S corporation election is
Everything else on this page follows from one filing. These are the terms of it, entered as line items.
- What it is
- A federal tax election, not a kind of company. A corporation or an LLC that qualifies asks the IRS to tax it under Subchapter S of the Internal Revenue Code.
- Who can make it
- A domestic company with a limited number of shareholders, all of them eligible ones (individuals, certain trusts and estates), and only one class of stock. Partnerships, corporations and nonresident aliens cannot hold shares.
- How it is made
- Form 2553, signed by every shareholder and filed with the IRS within the window the instructions set. Some states ask for their own filing on top.
- What it changes
- Profit passes through to the owners’ personal returns instead of being taxed at the company first, and owners who work in the business become employees of it.
- What it files
- An annual Form 1120-S for the company, and a Schedule K-1 to each shareholder showing their share of income, deductions and credits.
Earnings
Reasonable salary comes before any distribution
An owner who provides services to the company has to be paid a reasonable wage for them before taking profit out as a distribution. The IRS and the courts look at the facts of the job, not a fixed share of profit.
Training and experience
What the owner brings to the role, and what someone with the same background would be paid for it.
Duties and responsibilities
The work actually done, from running the company to serving its customers.
Time and effort devoted
Whether the owner works in the business full time, part time or only occasionally.
Comparable pay
What similar businesses pay for similar services, which is the test the other factors are weighed against.
Dividend history
How much has been paid out as distributions compared with what has been paid as salary.
How pay is set
Compensation agreements, the timing of bonuses, and whether a formula is used to decide the wage.
None of these factors produces a number on its own. A reasonable salary is a judgment about the work, written down with the evidence behind it.
Distributions
How distributions are treated
A distribution is profit paid out to owners. It carries no payroll withholding, but it is not tax free, and it comes with rules of its own.
Taxed whether taken or not
Each owner pays income tax on their share of the profit in the year it is earned, even if the company keeps the cash. A distribution is a payout of income already counted, not new income.
Paid in proportion to ownership
One class of stock means distributions follow the share register. Paying one owner out of step with their stake can put the election itself at risk.
Limited by basis
An owner’s basis rises with money put in and income passed through, and falls with losses and distributions. A distribution beyond basis is generally taxed as a capital gain.
Not a substitute for wages
Where an owner works in the business and takes distributions instead of salary, the IRS can treat those payments as wages and assess the payroll tax, penalties and interest that go with them.
Taxes
Payroll obligations, and the state taxes on top
Putting an owner on payroll makes the company an employer, with the filings that come with it. The state then adds a layer of its own, and that layer differs more from place to place than the federal one does.
Payroll, federal
- Federal income tax
- Withheld from every paycheck the owner-employee receives, based on their Form W-4.
- Social Security and Medicare
- The employee share withheld from wages, and the employer share paid by the company on top.
- Federal unemployment tax
- Paid by the company on wages, and reported once a year.
- Payroll returns
- Federal employment tax returns filed each quarter, with deposits made on the schedule the IRS assigns.
- Year-end forms
- A W-2 for each employee, owners included, filed with the Social Security Administration.
State and local
- Recognition
- Most states follow the federal election. A few do not, or need a separate state election before they will.
- Entity-level tax
- Some states and cities charge the company its own franchise, privilege or minimum tax, whatever its pass-through status.
- Payroll at state level
- State income tax withholding and state unemployment insurance on the owner’s wages, where the state has them.
- Owners in other states
- Nonresident shareholders may face state withholding, or a composite return filed for them by the company.
- Pass-through entity tax
- Many states now let the company elect to pay state income tax on the owners’ behalf, which changes where the deduction falls.
Notes
Questions this guide is organised around
The questions S corporation owners ask about the election, their salary, their distributions and the taxes that follow, grouped the way the statement above is laid out.
Making the election
- Can an LLC elect to be taxed as an S corporation, and what changes when it does?
- What happens if Form 2553 is filed late?
- Does the state need to be told separately?
Reasonable salary
- How is a reasonable salary decided for an owner who does several jobs?
- Does an owner who works part time still need to be on payroll?
- What evidence supports the salary an owner has chosen?
Distributions
- When can an owner take a distribution, and how often?
- What is basis, and how does an owner keep track of it?
- What happens when one owner is paid out ahead of the others?
Payroll and state tax
- Who runs payroll when the only employee is the owner?
- Which states tax an S corporation at the company level?
- How does a pass-through entity tax election work?