S Corp Salary vs. Distributions: How to Choose the Right Mix for Taxes and Compliance

Balancing salary and distributions is one of the most persistent challenges for S corporation owners. The structure is efficient but only when owners set compensation intentionally and revisit it as the business grows.

Most owner questions come down to how to keep compensation aligned with the work being performed, how distributions fit into overall tax planning and how year-end timing affects payroll and basis calculations.

How Low Is Too Low for Reasonable Compensation

Reasonable compensation is not a fixed dollar amount. It is a function of the role you perform, the hours you work and what it would cost your business to hire someone else to do the same job.

Owners often underestimate how many functions they cover. Many fill several operational roles at once, which means their work would cost more to replace than they expect.

Too low is any number that does not reflect the value of the services actually performed. If an owner manages staff, runs day-to-day operations, handles sales, performs technical work or fills a specialized role, the salary must reflect that. If the business has employees covering those responsibilities and the owner only provides oversight, the salary can shift accordingly.

The challenge is avoiding a number that is disconnected from reality. Salary should match the workload you provide to the company, not the minimum needed to keep payroll active.

How Distributions Affect Payroll, FICA and Estimated Taxes

Distributions are a key advantage of the S corporation structure. They bypass payroll tax, which is why many owners prioritize them. The tradeoff is that salary covers Social Security and Medicare obligations while distributions do not. If the salary is set too low, you may end up relying on estimated taxes to cover the income portion without building sufficient FICA contributions through payroll. Distributions do not change taxable income, but they do reduce basis, which affects how much can be withdrawn tax-free.

Owners who take large distributions relative to their salary can see mismatches in their quarterly estimated tax planning. Payroll withholds federal income tax, state tax and FICA. Distributions provide none of those withholdings, so owners must plan their quarterly payments carefully. Many underestimate their tax liability because they assume distributions behave like wages, and they do not.

Benchmarks CPAs Use to Establish Salary

• Role: What work do you actually perform. A technical specialist, a manager and an administrative owner have very different compensation profiles. Many S corporation owners function as both operator and manager, which raises the salary benchmark.

• Industry: Compensation varies significantly by industry. What is reasonable for a consulting practice is very different from construction, medical, real estate or trades. A CPA can look at common replacement salary data, industry surveys and regional averages.

• Hours: Owners who work part-time or operate in a seasonal business can adjust salary accordingly. The number of hours performed each month, quarter or year affects the amount needed to align pay with real workload.

• Replacement Cost: Ties all of these together. If your business had to hire someone to perform the work you do, the cost of hiring that person is the clearest benchmark for your salary.

How Often Should Salary Be Adjusted

Salary should be revisited at least annually. Many owners increase compensation when revenue grows or when they shift into a more defined leadership or oversight role. Others adjust downward if they step back from daily work.

Significant changes in staff also matter. When an owner hires a team to absorb operational work, the owner’s salary can move closer to a management benchmark. When the owner continues handling most of the essential functions, salary should reflect that.

Compensation should also be reviewed when distributions become a much larger share of total income. If distributions rise substantially without any change to salary, it may signal that the balance needs to be recalibrated.

What Happens if Distributions Exceed Basis

The basis determines how much you can withdraw tax-free. Distributions that exceed basis are taxable, which comes as a surprise to many first-time S corporation owners. Basis increases with income and contributions and decreases with distributions and certain losses.

If distributions reduce the basis to zero, any amount beyond that point becomes taxable. This issue often appears late in the year when an owner takes large distributions without reviewing current year profits, accumulated basis or prior retained earnings.

Tracking basis throughout the year prevents accidental taxable distributions and keeps year-end planning predictable.

Why Your CPA Wants Payroll Run Before December 31

Year-end payroll locks in the amount of salary recognized for that tax year. If an owner needs additional wages to align with industry benchmarks, support reasonable-compensation expectations or balance salary relative to distributions, that payroll must be completed before December 31.

This is also the cutoff for withholding federal and state taxes through payroll, for issuing accurate W-2s and for matching compensation with the correct year’s basis and income calculations.

Completing payroll after year-end cannot retroactively apply to the prior tax year, which is why CPAs push owners to review compensation in November or December rather than waiting until January.

Support for Structuring Your S Corporation Compensation in the Greater Phoenix Area

Balancing salary, distributions, basis and year-end payroll requires a clear and practical approach rather than a one-size-fits-all rule. H&H Accounting Services helps S corporation owners evaluate their responsibilities, build an appropriate salary strategy, plan distributions and prepare year-end payroll without surprises.

Contact our CPA at H&H Accounting Services by calling (480) 561-5805 and schedule a review of your compensation structure.