How Much Distributions Should S-corp Owners Take

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Introduction

S-Corporations offer business owners flexibility when it comes to receiving compensation. A critical question many S-Corp owners ask is: How much should I take in distributions? This is a key decision with important tax implications. Taking too much or too little in distributions can lead to unwanted IRS scrutiny or missed opportunities for tax savings.

In this blog post, we’ll dive into the right approach for determining how much to take in distributions from your S-Corp. We’ll cover the balance between reasonable compensation, tax benefits, and staying compliant with IRS guidelines.

What Are S-Corp Distributions?

S-Corporation distributions are payments made to shareholders from the company’s earnings. For tax purposes, distributions are treated differently from wages or salaries. Owners of S-Corps have the advantage of taking some income in the form of distributions, which are typically not subject to Social Security and Medicare taxes, resulting in potential tax savings.

How Are Distributions Taxed?

Distributions to S-Corp shareholders are typically not taxed twice, thanks to the pass-through nature of S-Corps. This means the company’s income is only taxed at the individual level, and distributions themselves aren’t taxed as long as they do not exceed the shareholder’s basis.

Balancing Reasonable Compensation and Distributions

The IRS requires S-Corp owners to take “reasonable compensation” in the form of wages before taking any distributions. This is one of the most important points to understand when determining how much to take in distributions.

What Is Reasonable Compensation?

Reasonable compensation refers to a fair salary that an S-Corp owner would pay themselves for the services they provide to the company. This wage is subject to payroll taxes, including Social Security and Medicare.

According to the IRS, determining reasonable compensation should consider factors like:

Industry standards for similar roles.
The size and profitability of the S-Corp.
The time spent by the owner on the business.

What Happens If You Don’t Pay Yourself Reasonable Compensation?

If an S-Corp owner takes too little in wages and too much in distributions, the IRS could reclassify some of the distributions as wages. This would result in payroll tax penalties, interest, and possibly additional taxes owed. To avoid this, always ensure you’re paying yourself a reasonable salary.

How to Calculate Distributions for an S-Corp Owner

Once you’ve established reasonable compensation, the next step is to determine how much to take in distributions. There isn’t a strict IRS guideline on the exact amount, but certain factors can guide you.

Step 1: Determine Your Company’s Net Income

Your S-Corp’s net income is a key factor in determining how much you can distribute to shareholders. Subtract your operating expenses, including your salary, from your gross revenue to calculate net income.

Step 2: Calculate Shareholder Basis

Before taking distributions, it’s essential to understand the concept of shareholder basis. This is the amount you’ve invested in the company plus retained earnings, minus previous distributions. You can only take distributions up to your basis. If distributions exceed your basis, the excess is considered a capital gain and subject to additional taxes.

Step 3: Keep Reserves for Company Needs

While it’s tempting to take out as much money as possible, your S-Corp still needs working capital. Make sure to leave enough reserves to cover future operating expenses, debt payments, and unforeseen costs.

Tax Benefits of S-Corp Distributions

S-Corp distributions are often seen as a tax-saving strategy because they are not subject to payroll taxes like Social Security and Medicare. Here’s a breakdown of why they’re beneficial:

No Payroll Taxes: Unlike wages, distributions are not subject to FICA taxes (Social Security and Medicare), saving owners 15.3% in payroll taxes.
Avoiding Double Taxation: S-Corp income is taxed only at the shareholder level, avoiding the double taxation that affects C-Corporations.

However, always remember the balance—taking too many distributions without paying a reasonable salary can raise red flags with the IRS.

IRS Guidelines and Common Pitfalls

While distributions can save taxes, the IRS is particularly vigilant about ensuring S-Corp owners do not underpay themselves in wages. Here are a few common pitfalls to avoid:

Failing to Pay Reasonable Compensation

As discussed earlier, underpaying yourself in wages and taking most of your income in distributions can lead to IRS penalties. Pay yourself a salary that reflects your role and the industry standards.

Taking Distributions That Exceed Basis

If your distributions exceed your shareholder basis, the excess is taxed as a capital gain. To avoid this, carefully track your basis and distributions.

Not Keeping Proper Records

The IRS expects S-Corp owners to keep detailed records of their salary, distributions, and basis. Failing to maintain proper documentation can lead to complications in an audit.

Best Practices for S-Corp Distributions

To maximize your tax savings and remain in compliance, here are some best practices:

Pay Yourself Regularly: Take a reasonable salary at regular intervals, just like any other employee.
Plan Distributions at Year-End: Once you have a clear picture of your company’s financial health, take distributions toward the end of the year.
Keep Reserves: Leave enough capital in your business to cover future expenses and growth opportunities.
Consult a Tax Professional: Every business is different, and a CPA can help you navigate complex tax rules while minimizing your tax liability.

FAQ

Can I Take Only Distributions Without Paying Myself a Salary?

No. The IRS requires S-Corp owners to take a reasonable salary before taking distributions. Failing to do so could result in penalties and reclassification of distributions as wages.

How Do I Know What’s Considered Reasonable Compensation?

Reasonable compensation depends on factors such as the services you provide, industry standards, and your company’s profitability. Consulting a tax professional can help you determine an appropriate salary.

What Happens If I Take Distributions That Exceed My Basis?

Distributions that exceed your shareholder basis are subject to capital gains tax. It’s essential to track your basis carefully to avoid this tax consequence.

How Often Can I Take Distributions?

There’s no set limit on how often you can take distributions. However, it’s common for S-Corp owners to take distributions quarterly or at the end of the year after calculating their net income and basis.

Are Distributions Subject to Payroll Taxes?

No, distributions are not subject to Social Security, Medicare, or unemployment taxes, which is why many S-Corp owners use them to save on payroll taxes.

Conclusion

Deciding how much to take in distributions as an S-Corp owner is a balance between maximizing tax savings and complying with IRS guidelines. By paying yourself a reasonable salary and carefully managing your shareholder basis, you can enjoy the tax benefits of S-Corp distributions while avoiding common pitfalls. For personalized advice, it’s always best to consult with a tax professional.

Need help navigating your S-Corp distributions? Contact our team of experienced CPAs today to ensure you’re maximizing your tax savings and staying compliant with IRS rules.