The S Corp Owner's Compensation Dilemma
Balance immediate payroll tax savings with long-term financial security. This tool helps you explore the trade-offs of setting your W-2 salary vs. taking shareholder distributions to find your strategic sweet spot.
Interactive Scenario Modeler
Adjust the sliders to model your compensation strategy and see the real-time financial impact.
Financial Breakdown
Your estimated take-home and taxes.
Audit Risk Meter
IRS scrutiny increases with very low salary-to-income ratios.
Cash Flow Allocation
How your business income is divided.
The Rules: Salary vs. Distributions
Understanding the fundamental tax differences is the first step in making a strategic choice. Your compensation must be split between a "reasonable salary" for your work and distributions of profit.
W-2 Salary
- ✔Considered a deductible business expense, lowering company profit.
- ✘Subject to Social Security & Medicare (FICA) taxes for both employee and employer.
- ✘Subject to Federal and State unemployment taxes.
- ✔Builds your earnings record for Social Security retirement and disability benefits.
- ✔Acts as the basis for retirement plan contributions (e.g., Solo 401k).
Shareholder Distributions
- ✘Not a business expense; paid from after-tax profits.
- ✔NOT subject to FICA or unemployment taxes - the primary tax advantage.
- ✘Do NOT build your Social Security earnings record.
- ✘Cannot be used to calculate retirement plan contributions.
- ✔Generally tax-free to you, as long as you have sufficient stock basis.
The Risks: The Cost of Being Unreasonable
Setting an unreasonably low salary is a major red flag for the IRS. If challenged, they can reclassify distributions as wages, leading to severe financial consequences.
Back Payroll Taxes
You'll owe the employer and employee share of FICA and unemployment taxes on the reclassified amount.
Steep Penalties
Expect a 20% accuracy-related penalty, plus penalties for failure to file and pay payroll taxes on time.
Compounding Interest
Interest is charged on all unpaid taxes and penalties from their original due date, swelling the final bill.
Case Study: David E. Watson, P.C. v. Commissioner
An accountant paid himself a $24k salary while taking over $175k in distributions. The IRS used market data to argue his services were worth ~$91k. The court agreed, reclassifying ~$67k of his distributions to wages, subjecting them to back taxes, penalties, and interest. The key lesson: data-driven analysis of fair market value will always win over arbitrary salary figures.
Your Strategy: Finding & Defending Your Number
The best defense is a good offense. Don't just pick a number; build a case for it. The process of determining your salary is as important as the salary itself.
Define Your Roles
Inventory all the "hats" you wear: CEO, salesperson, technician, administrator. Be specific about your duties and time commitment for each role.
Gather Market Data
Research what similar positions earn in your industry and geographic area. Use sources like the Bureau of Labor Statistics, salary websites, and industry surveys.
Calculate & Blend
Assign a market-rate salary to each role you perform and blend them based on the percentage of your time spent on each. This creates a strong, defensible baseline salary.
Document Everything
Formalize your findings in an annual "Reasonable Compensation Report." Include your methodology, data sources, and calculations. Ratify it in your corporate minutes. This is your number one defense in an audit.