How Much Salary Do I Have to Pay Myself If I Have an S-Corp?

Javier made the S election three years ago. A friend with a similar business recommended it and told him he would pay less in taxes. That's true. What the friend only half explained was how.

So Javier did what seemed logical: he paid himself no salary, or a token one, and takes everything else out of the company account as he needs it. The first year, nobody said anything. The second year, neither. And with every year that goes by, the idea that he found the magic formula gets stronger.

That is probably the most exposed position the owner of an S-Corp (whether an LLC or a CORP) can be in. It's worth understanding why, and above all understanding that here there is no formula, however many people swear there is.

Where the temptation comes from

In an S-Corp, money reaches the owner through two different channels, and each one is treated differently.

Salary

is pay for working. It goes through payroll, with its withholdings and payroll taxes, and it generates a W-2.

Distribution

is the sharing of profit with the shareholders. It is not pay for working and it doesn't carry payroll taxes.

That's all there is to it. If you move money from the first column to the second, the payroll tax bill goes down. The more salary you turn into distribution, the lower it gets.

That's why the question exists. And that's why the rule that limits it exists.

What the rule asks for

The principle is short: if you are a shareholder and you also work in your company, you are an employee of it, and the company has to pay you a reasonable salary for that work before distributing profit. It doesn't say you can't take distributions. It says work gets paid as work. What is left after that is the owner's profit.

The formula everyone quotes and that doesn't exist

Let's be direct here. The friend who recommended the election to Javier also gave him a ratio: this much salary, this much distribution. In any conversation on this subject, someone shows up with one. Those ratios don't come from any rule. They are office habits that got repeated until they sounded like law. Nobody published them and nobody stands behind them. The practical problem is that a ratio doesn't look at the only thing that matters: how much the work you do is worth. Two owners with the same profit can have very different reasonable salaries, because one works full time running the operation and the other put up the capital and stops by once a month.

What is actually looked at

The right question is not "what percentage?" but this one:

If I weren't here, how much would I have to pay someone to do what I do?

Around that question, concrete things are looked at:

What you actually do.

Not the title, the duties. Selling, managing, supervising, producing, negotiating. An owner who does everything has a more expensive job than one who only supervises.

How much time you give it.

Full time is not the same as a few hours a week.

Your training and experience.

What you bring to the position is part of what the position is worth.

What the market pays.

What someone earns doing that same job at a similar business in a similar area. This is the most solid reference point there is.

What the company can afford.

A business that barely generates anything can't sustain a high salary, and that counts too.

What you pay everyone else.

If your employee earns more than you while doing less, there is something to explain.

The proportion between what you took as salary and what you took as distribution.

When almost everything came out through the second route, the question asks itself.

The riskiest case: zero salary

What happens if the salary doesn't hold up

The consequence is not that distributions get forbidden. It's that they get reclassified.

What you also lose by paying yourself too little

This part rarely gets taken into account, and it's the one that hurts most in the long run.

Your Social Security record.

Your credit is built on what you reported as salary. Reporting little for years affects what you are entitled to later. Distributions don't build that record.

Your ability to save for retirement.

Several retirement plans are calculated on the compensation you receive as an employee. Low salary, low ceiling.

What a bank sees in you.

When you apply for a loan, your W-2 is the cleanest proof of your income. An owner with a token salary shows up to the bank as someone who earns little, however well the business is doing. That topic has its own article.

How a number gets supported

A reasonable salary is not a number you declare. It's a number you can explain. What it helps to have:

A market reference. What is paid for that work in your industry and your area, with the source noted.

A description of what you do. Real duties and time spent.

A written decision. The owner's compensation is a company decision, and company decisions get documented. Minutes or a resolution setting the salary, with the date, close the circle.

Consistency. That what was agreed is what was actually paid, and that the rest is recorded as what it is.

Warning signs

You have an S election and have never received a W-2 from your company
Your salary is a round number nobody knows the origin of
You were given a percentage and not a reasoning
Almost everything you took out last year was distribution
You work full time and pay yourself as if part time
One of your employees earns more than you
Your salary has never changed, even though the business grew

What to do if this describes you

Put a number on the work, not on the profit.

Start with what it would cost to replace you. That is the floor of the conversation.

Find your reference and keep it.

Salary data for your industry and your area. You don't need a study: you need a source you can show.

Document the decision.

Minutes setting the compensation, dated before the payment.

Set up real payroll.

A reasonable salary without payroll doesn't exist. The salary has to go out with its withholdings and its reporting.

Check whether the S election works for you.

It's the underlying question, and a lot of people skipped it. If your business doesn't yet generate enough, the savings don't cover the cost of administering it. That topic also deserves its own article.

If you've been doing it this way for years, get help sorting it out.

Prior years have a treatment, but they don't resolve themselves and they aren't fixed by changing this year's number.

Javier, the day he sat down to work out the number

Nobody audited Javier. What happened was more boring: he went to ask for a loan for a truck, they asked for his W-2, and he didn't have one.

He sat down with the person who does his taxes and they started with the usual question: how much would it cost to hire someone to do what he does. They looked up what is paid for that work in his area, wrote it down, and signed minutes setting his compensation. They set up payroll the following month.

His tax bill went up, but less than he feared, because the company deducts the salary. What he got in exchange was a number he can explain in one sentence, and a W-2 to show when someone asks.

In short

The savings exist and are legitimate, but they live on the other side of a line. On this side is the salary that corresponds to your work, and that has to be paid first.

If you couldn't explain where the number for your salary came from, that is the moment to sit down and build it. Explaining it later, when someone else is asking, is a much more expensive conversation.

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