S Corp Owners Must Set Reasonable Salary Before Taking Distributions
Accounting expert David Riggs outlines why S corp owners must document reasonable compensation before drawing shareholder distributions to satisfy IRS rules.
S corporation owners who also work in their businesses cannot simply take distributions and skip a formal paycheck, according to accounting expert David Riggs, who addressed the issue in a recent HelloNation feature. The IRS requires working shareholders to pay themselves a reasonable salary before any profit distributions are made, a rule designed to prevent business owners from sidestepping payroll taxes by characterizing all income as pass-through distributions.
Riggs explained that the determination of what qualifies as "reasonable" compensation is not arbitrary. Relevant factors include the owner's specific job duties, professional experience, hours devoted to the business, and what comparable employees in similar roles earn in the open market. Without a defensible methodology behind the salary figure, S corp owners risk IRS scrutiny and potential reclassification of distributions as wages — triggering back payroll taxes, interest, and penalties.
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The distinction between salary and distributions carries significant tax consequences. Salaries are subject to Social Security and Medicare taxes, while shareholder distributions generally are not. That gap creates an incentive to minimize salary, but the IRS has consistently challenged arrangements where compensation appears unreasonably low relative to the value of services rendered by the owner-employee.
Documentation is a central theme in Riggs's guidance. Maintaining written records that support the salary decision — including industry compensation surveys, job descriptions, and time logs — provides a factual basis if the IRS questions the owner's approach. Professionals advising small business owners increasingly treat reasonable compensation analysis as an annual compliance exercise rather than a one-time setup decision.
For S corporation owners navigating these rules, working with a qualified accountant or tax advisor to establish and revisit compensation levels each year can reduce audit exposure and help ensure the business structure delivers its intended tax advantages. Continue reading at All Financial Services & Investing.
