How Much of a Salary or Draw Can You Take?

Salary & Distributions for S Corporation Officers and Shareholders

Many business owners who have incorporated pay themselves a draw or dividend in addition to or instead of a regular paycheck. This practice can get you in trouble if you don’t follow the 60/40 rule.

Courts have consistently held that S corporations must pay reasonable compensation to a shareholder-employee (owner) in return for services that the employee provides to the corporation before non-wage distributions (money paid to you that does not go through regular payroll) may be made to the shareholder-employee.  Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for the services rendered to the corporation.

According to the IRS, an owner/shareholder of an S-corporation you must pay them self a reasonable wage (through payroll).  At a minimum, you should pay yourself gross wages equal to 150% of the total you take out in draws/distributions.  This is known as the 60/40 rule.

Example: If you normally take $100,000 out of the business, it should be split so that $60,000 is paid as wages to yourself and the other $40,000 is paid out in distributions to yourself.  You have to be able to justify your pay as “reasonable”.  According to the IRS, reasonable pay is the amount that similar companies pay for the same, or similar, services.

Standard Payroll through Salary and Wages

Here we are referring to typical payroll that includes payroll taxes and withholdings.

• When you pay yourself a wage through your S Corporation, your business gets to take that amount as a deduction on the S Corporation tax return under Officer’ Compensation.
• Your business will also have to generate payroll reports and pay payroll taxes in a timely manner including the employer portion of Social Security and Medicare, federal unemployment, and state unemployment which are all deductible payroll tax expenses.
• You personally will have withholdings on your wages for Social Security, Medicare, federal income tax, and state income tax just as any other employee would.
• You will receive a Form W-2 at the end of the year from your payroll provider detailing the gross income and withholding amounts.  The gross pay included in Box 1 of your Form W-2 will be included as income on your personal tax return.

Draws, Distributions, and Dividends

Draws, distributions, and dividends are ways of paying yourself without creating an actual paycheck (or direct deposit) which includes the typical payroll taxes and withholdings.

• When you pay yourself distributions through your S-Corporation such as dividends, rents, personal expenses, and personal tax liabilities, these amount are not included as deductions on your business tax return (Form 1120S).
• The S-Corporation does not pay any payroll taxes on the distributions.
• The distributions that you receive are not deducted from your S Corporation’ income. You will not receive a W-2 or a 1099 for the distribution amount.  You also do not have to pay Social Security or Medicare tax on the distribution amounts.
• When you pay yourself using draws, distributions, or dividends, you are not withholding taxes. Many owners get themselves into trouble at tax time because they end up owing taxes they weren’t planning on. This can result in stiff penalties and interest. Be sure that you pay estimated taxes during the year.
• Possible IRS audit of the corporation’ records.
• Loss of S corporation status and liability protection.
• Distributions/Dividends being treated as wages with federal employment taxes being imposed and, subject to late payment penalties and interest for not paying these taxes on a timely basis.

Possible Consequences of Not Adhering to these Guidelines

• Possible IRS audit of the corporation’ records.
• Loss of S corporation status and liability protection.
• Distributions/Dividends being treated as wages with federal employment taxes being imposed and, subject to late payment penalties and interest for not paying these taxes on a timely basis.