As an S Corp owner-employee, understanding how the IRS views money taken out of your business is crucial. The IRS considers all withdrawals as wages first, until they exceed “reasonable compensation” for your role. This ensures payroll taxes are paid on earnings tied to your labor.
Wages vs. Distributions: The Basics
- Wages First: Any money you withdraw is treated as wages subject to payroll taxes until you’ve paid yourself a reasonable salary.
- Distributions Second: Only amounts above reasonable compensation can be classified as distributions, which are not subject to payroll taxes.
For example, if industry standards suggest a $50,000 salary and you withdraw $70,000, the first $50,000 is wages. The remaining $20,000 can be a distribution of earnings.
Why It Matters
Minimizing salary to maximize distributions and avoid payroll taxes is a red flag for the IRS. Auditors increasingly target S Corps with low salaries and high profits. If they find insufficient wages, the IRS can reclassify distributions as wages, resulting in back taxes and penalties.
How to Handle Low-Earning or Multi-Year Scenarios
- Pay What You Can: Allocate as much as possible toward wages and keep distributions minimal or preferably nonexistent.
- Multi-Year Planning: If your current-year distributions include profits retained from prior years, clarify this in your records. However, remember that even in these cases, withdrawals are treated as wages first for the current year’s labor. Prior years’ retained earnings can only be tax-free after your salary requirements are satisfied.
Preparing for an Audit
The best defense is preparation. Create a written analysis showing what replacing you with an outsider would cost. IRS auditors are used to encountering taxpayers with no documentation of reasonable compensation, so even a half-baked analysis (e.g., industry data or a memo) can be enough to convince them to focus elsewhere.
Paying your salary first and keeping records on how you determined your reasonable compensation is how you avoid the hassle of dealing with the IRS on this issue.
