S Corp Owners Must Set Reasonable Salary Before Taking Distributions

S corporation owners who draw income from their businesses cannot simply take shareholder distributions without first establishing a reasonable salary, according to accounting expert David Riggs, writing in HelloNation. The distinction matters because salaries are subject to payroll taxes while distributions are not, making the compensation decision a frequent target of IRS examination.

Riggs identifies several factors that go into determining what counts as reasonable compensation, including the owner's specific job duties, professional experience, hours devoted to the business, and what comparable workers in similar roles earn in the open market. Without a defensible rationale tied to those benchmarks, an S corp owner risks having the IRS reclassify distributions as wages — triggering back taxes, interest, and potential penalties.

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Documentation is central to the expert's guidance. Riggs underscores that salary decisions should be supported by written records that reflect the owner's role and the market rate analysis used to arrive at the compensation figure. That paper trail can be critical if the business is ever audited, providing evidence that the owner acted in good faith rather than structuring pay solely to minimize employment taxes.

The issue carries broader relevance as S corporations remain one of the most popular small-business structures in the United States, prized partly for the tax efficiency that distributions can provide. However, that efficiency is contingent on meeting IRS reasonable-compensation standards, and advisers generally recommend revisiting the salary figure whenever the owner's duties or business revenue change materially.

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