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 avoid IRS scrutiny.
S corporation owners who take shareholder distributions without first paying themselves a reasonable salary risk running afoul of IRS rules, according to accounting expert David Riggs, writing in HelloNation. The distinction matters because salaries are subject to payroll taxes while distributions are not, creating a financial incentive that regulators closely monitor.
Riggs emphasizes that determining what qualifies as reasonable compensation is not arbitrary. Factors such as the owner's specific duties, relevant experience, hours worked, and pay rates for comparable positions in the same industry all feed into a defensible salary figure. Without documented support for the number chosen, an S corp owner is exposed to potential reclassification of distributions as wages by the IRS, which would trigger back payroll taxes, interest, and penalties.
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The sequence of compensation matters as much as the amount itself. Working owners — meaning those actively involved in running the business — must receive their reasonable salary before any distributions are drawn. Taking distributions first, or skipping salary entirely, is one of the more common and costly mistakes S corp owners make, Riggs notes.
Record-keeping is a central theme in Riggs' analysis. Supporting documentation that justifies the salary decision serves as the primary defense in an audit scenario. That documentation should reflect the market research, role comparisons, and internal factors considered when the compensation figure was set, and it should be revisited as business conditions or the owner's responsibilities change over time.
For small business owners weighing the tax advantages of S corp status, understanding the interplay between salary and distributions is foundational to staying compliant while managing self-employment tax liability effectively. Continue reading at All Financial Services & Investing.
