Key Takeaways

  • S corp owners who provide significant services must pay themselves a reasonable salary to comply with IRS rules.
  • Owners can split income between salary (taxed as ordinary income) and distributions (not subject to self-employment tax).
  • A “reasonable salary” is determined by job duties, industry standards, business profits, and more.
  • Payment must be made through payroll with proper withholding and reporting using IRS forms like W-2 and 941.
  • Misclassifying payments or underpaying yourself can trigger IRS audits and penalties.
  • Tools like payroll software or accountant support can help streamline compliance.
  • Considerations like healthcare benefits and retirement contributions also affect how you pay yourself.
  • Professional legal or tax advice can ensure your compensation strategy meets IRS standards and benefits your business financially.

S corp how to pay yourself is an important thing to know if you are a shareholder in an S Corp but also conduct work for the business.

The reason for this is because the Internal Revenue Service (IRS) closely monitors transactions that occur between the S Corp and its shareholders, particularly those shareholders who conduct substantial services for the business. Therefore, if you are in fact doing substantial work for the S Corp, then the IRS expects you to pay yourself a “reasonable” compensation for that work. Along with a reasonable compensation, you can also receive dividends from the S Corp; these dividends are not taxed.

While dividends aren’t taxed, any compensation you receive is taxed at the typical personal tax rate. For this reason, most shareholder-employees would prefer to be paid strictly through dividends as opposed to receiving compensation, as they can avoid paying taxes if only receiving money through dividends. But before you choose to go this route, remember that the IRS will take notice. So it is best that you pay yourself a salary as well as dividends to avoid being questioned by the IRS.

Substantial Services Performed by a Shareholder

If you do substantial work for the S Corp and you are also a shareholder, then you will be considered an employee too, i.e., shareholder-employee. This means that the S Corp has to pay you a salary. You can choose to receive a salary as either an independent contractor or employee.

If you choose to be considered an employee, then the business will be required to withhold taxes from any wages and submit the withholdings on Schedule K-1 to the IRS on your behalf. If, however, you choose to operate as an independent contractor, then you are responsible for paying taxes.

Why Reasonable Compensation Matters to the IRS

The IRS closely examines how S corp owners pay themselves to ensure they are not avoiding payroll taxes. A common red flag is when an S corp owner takes large distributions but pays themselves little or no salary. In these cases, the IRS may reclassify those distributions as wages and apply penalties and back taxes.

To stay compliant, shareholders performing substantial work must receive "reasonable compensation" before taking distributions. The IRS defines reasonable compensation as the amount that would typically be paid for similar services by similar businesses in similar circumstances. Failing to meet this requirement can result in audits, additional taxes, and even loss of S corp status.

Factors to Consider When Paying Yourself

There are several factors you should consider when paying yourself for the work you do. Be sure to distribute some compensation as dividends. While you need to pay yourself a reasonable salary, you can still earn money through dividends, thereby reducing your taxes to an extent. Combine distributions and wages if you perform some functions for the business. Remember that the pay should be appropriate to the level of work being performed.

Some factors to think about include the following:

  • Consider splitting your income through dividends and wages. For example, if you want to pay yourself $200,000, then perhaps you can receive compensation of $100,000 and dividends of $100,000.
  • Pay yourself equivalent to what others in the industry would be making for that specific work.
  • Create an employment letter that will be approved by all of the S Corp shareholders.
  • Determine how many allowances you would like to claim on your W-4. Remember that the more allowances you claim, the fewer taxes that will be taken out.
  • If you fill out W-9, then the S Corp won’t withhold taxes from your wages, so you will be required to pay taxes yourself. Further, if you operate as an independent contractor and not an employee of the S Corp, you will need to pay taxes yourself.
  • Deduct federal income taxes from your paycheck, along with other pre-tax items such as medical/life insurance premiums and 401k contributions.

Salary vs. Distributions: Tax Implications

One of the biggest benefits of forming an S corp is the ability to split your income between salary and distributions, which reduces self-employment taxes. Here’s how it works:

  • Salary is subject to income tax, Medicare, and Social Security (FICA) taxes.
  • Distributions are subject to income tax but not payroll taxes, offering a potential tax savings.

However, distributions can only be taken after you’ve paid yourself a reasonable salary. Paying all income as distributions—while tempting for tax savings—violates IRS rules and may result in reclassification of income and penalties.

To maintain compliance and optimize your tax liability:

  • Pay yourself a fair salary first.
  • Take distributions only from profits remaining after salary and business expenses.
  • Work with a tax professional to set up an appropriate compensation strategy.

How to Determine a Reasonable Salary

Setting a reasonable salary involves considering multiple variables, including:

  • Role and responsibilities: The more vital your role, the higher your salary should be.
  • Industry standards: Benchmark against average compensation for your job title in your industry.
  • Business profitability: The salary should be financially sustainable based on the S corp’s earnings.
  • Education and experience: More qualified individuals typically earn more.
  • Time commitment: Full-time involvement warrants higher pay than part-time engagement.

You can also reference data from sources such as the Bureau of Labor Statistics, salary websites like Glassdoor, or consult a CPA or tax advisor. Documenting your method for setting a salary—through job descriptions, salary studies, or comparable roles—helps support your case in the event of an IRS audit.

Applicable Forms for S Corp Businesses, Employees, and Contractors

The S Corp must file Form 941 on a quarterly basis and make federal payroll tax deposits, which can be done online through the Electronic Federal Tax Payment System. If the shareholder elects to operate as an employee, then he or she will need to file taxes on a W-2. If choosing to operate as an independent contractor, then Form 1099 will need to be filled out. The IRS generally recommends S Corps to make payroll deposits once the business pays its employees.

The business is also responsible for paying fees through the Federal Unemployment Tax Act (FUTA), which is a specific kind of unemployment benefit insurance for unemployed workers of the company. Employees are never responsible for paying this type of insurance.

What About Health Insurance and Retirement Contributions?

If you're a more-than-2% shareholder in an S corp, fringe benefits such as health insurance and retirement plans are treated differently:

  • Health insurance premiums paid by the S corp on your behalf must be included in your W-2 income but can be deducted on your personal return if qualified.
  • 401(k) contributions must follow IRS limits and be included in payroll operations.
  • Some benefits, like cafeteria plans (Section 125), are not available to more-than-2% shareholders.

Planning these benefits carefully can help reduce overall tax liability while staying within legal bounds. Consult a qualified accountant or benefits specialist for help structuring these programs correctly.

Can S Corp Owners Use 1099s Instead of W-2s?

S corp owners who perform substantial services cannot legally pay themselves via a 1099 as if they were independent contractors. The IRS generally prohibits this because:

  • You are considered both a shareholder and an employee.
  • Paying yourself as a contractor avoids payroll tax obligations—an IRS red flag.

Instead, compensation must be reported via W-2, and appropriate payroll taxes must be withheld. Using 1099-NEC for self-payment can result in IRS reclassification, back taxes, and penalties. Reserve Form 1099 for actual contractors who are not owners or employees of the business.

Best Practices for Running S Corp Payroll

Once you’ve determined your reasonable salary, you’ll need to run payroll like any employer. This involves:

  • Setting a consistent pay schedule (weekly, biweekly, or monthly)
  • Withholding payroll taxes: This includes federal income tax, Social Security, Medicare, and applicable state taxes.
  • Submitting payroll tax filings such as:
    • Form W-2: For reporting employee wages
    • Form 941: For quarterly federal payroll tax returns
    • Form 940: For annual Federal Unemployment Tax (FUTA) returns
  • Using payroll software or providers to automate calculations and filings

Even single-member S corps need to follow these processes. Skipping payroll or paying lump sums without proper tax treatment can trigger penalties.

Frequently Asked Questions

1. How do I calculate a reasonable salary for myself in an S corp? Use industry data, your role, business revenue, and time commitment to determine a fair market wage. Consult a CPA for guidance.

2. Can I take only distributions and avoid salary taxes? No. If you perform substantial work for your S corp, the IRS requires that you first pay yourself a reasonable salary before taking distributions.

3. Is payroll required for a single-owner S corp? Yes. Even if you’re the only employee, you must set up payroll, withhold taxes, and file the appropriate forms like W-2 and 941.

4. Can I issue myself a 1099 as an S corp owner? No. Owners performing work for their S corp should be paid via W-2, not 1099. Issuing yourself a 1099 may trigger IRS penalties.

5. Do I have to pay unemployment tax (FUTA) on my own salary? Yes, S corps must pay FUTA for employees, including shareholder-employees. This is filed annually using Form 940.

If you need help learning more about S Corporations or how to pay yourself, along with what constitutes reasonable compensation, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.