S Corporation Working Member Pay: What Small Business Owners Need to Know

If you've elected S corporation status for your business, congratulations! You've made a smart move that can save you thousands in taxes. But here's the catch, you need to pay yourself properly, or the IRS might come knocking with some hefty penalties.

The golden rule for S corp owners who work in their business is simple: you must pay yourself a reasonable salary through W-2 wages before taking any distributions. This isn't a suggestion or a best practice, it's a legal requirement that the IRS takes very seriously.

Why the IRS Cares About Your Pay

Let's start with the basics. When you're an active owner in your S corporation, you're wearing two hats: you're both an employee and a shareholder. As an employee, you need to receive wages that are subject to employment taxes (Social Security, Medicare, unemployment). As a shareholder, you can receive distributions that aren't subject to these taxes.

The IRS knows this creates a tempting opportunity. Without proper oversight, business owners might skip the salary entirely and just take tax-free distributions. That would mean missing out on billions in employment tax revenue, and Uncle Sam doesn't like that one bit.

What Exactly Is "Reasonable Compensation"?

Here's where things get a bit fuzzy. The IRS defines reasonable compensation as "the fair salary that would ordinarily be paid" for your role, but they don't give you a specific number. Instead, it's based on "all relevant facts and circumstances."

Think of it this way: if you had to hire someone else to do your job, what would you pay them? That's your starting point for reasonable compensation.

The key word here is "reasonable." You can't pay yourself minimum wage if you're running a successful consulting firm that brings in $500K annually. Conversely, you don't need to pay yourself a CEO salary if you're running a small local business.

Busting the Biggest Myths

The 50/50 Rule Is Complete Fiction

You've probably heard this one: pay yourself 50% salary and take 50% as distributions. Here's the truth, this rule doesn't exist anywhere in the tax code. It's made up, yet it's so widespread that even a third of accountants believe it's real.

Following this arbitrary split could actually hurt you. If market research shows your role should pay $80K, but you're only paying yourself $50K to stick to some imaginary 50/50 rule, you're leaving money on the table and potentially inviting IRS scrutiny.

The 60/40 Rule Is Also Fake

Same story with the 60/40 guideline. There's no legal basis for these percentage-based rules. The IRS doesn't care about your ratios, they care about whether your salary reflects what you'd pay someone else to do your job.

How the IRS Evaluates Your Pay

When the IRS looks at your compensation, they consider several factors:

Your Professional Background

• What's your training and experience?

• What are your specific duties and responsibilities?

• Are you the person making all the major decisions?

Time Investment

• How many hours do you work?

• Are you full-time or part-time in the business?

• Do you have other jobs or businesses?

Business Performance

• How profitable is your company?

• What do you pay other employees?

• How does your business compare to similar companies?

Market Rates

• What do comparable businesses pay for similar roles?

• What would you have to pay to replace yourself?

• Are there industry standards for your type of work?

The Tax Math That Matters

Let's talk numbers because that's where the rubber meets the road. On your salary, you'll pay:

• Social Security tax: 12.4% on wages up to $160,200 (2023 limit)

• Medicare tax: 2.9% on all wages, plus an additional 0.9% on wages over $200,000

• Federal and state income taxes

• Unemployment taxes

Half of the Social Security and Medicare taxes come out of your paycheck, and half are paid by your company.

Here's a real-world example: Let's say your S corp makes $150,000 in profit, and you determine a reasonable salary for your role is $75,000. You'd pay about $11,475 in total employment taxes on that salary. The remaining $75,000 could be taken as distributions with no additional employment taxes.

If you tried to skip the salary and take the full $150,000 as distributions, the IRS could reclassify it all as wages, meaning you'd owe employment taxes on the entire amount, that's about $22,950 in this example, plus penalties and interest.

Common Mistakes That Get Business Owners in Trouble

Taking Distributions Before Paying Salary

Some owners think they can take distributions throughout the year and then pay themselves a salary at year-end. Wrong! You need to be on payroll consistently if you're actively working in the business.

Paying Too Little to Save on Taxes

Yes, paying yourself less salary means lower employment taxes in the short term. But if the IRS determines your salary was unreasonably low, you could end up paying those taxes anyway, plus penalties.

Not Documenting Your Decision

Whatever salary you choose, be prepared to defend it. Keep records showing how you determined your compensation was reasonable: salary surveys, job descriptions, time logs, anything that supports your decision.

Forgetting About Payroll Requirements

Once you're paying yourself a salary, you need to run proper payroll. That means withholding taxes, filing quarterly returns, and issuing yourself a W-2 at year-end.

How to Set Your Salary the Right Way

Start by researching what others in similar roles earn. Check out:

• Bureau of Labor Statistics data

• Industry salary surveys

• Job postings for similar positions

• Compensation studies from professional organizations

Then adjust for your specific situation:

• Working part-time? Your salary can be proportionally lower

• Just starting out? You might justify a lower salary initially

• Highly experienced? You might warrant premium compensation

• Multiple roles? Add up the value of all your functions

Remember, you're not trying to minimize your salary: you're trying to set a reasonable one that you can defend if questioned.

When You Don't Need to Pay Yourself

There are a few situations where salary requirements might not apply:

• Your business isn't profitable

• You're not actively working in the business

• You're just a passive investor (though this is rare in S corps)

But once your business is making money and you're providing services to it, the salary requirement kicks in.

Planning for Success

Setting reasonable compensation isn't just about avoiding IRS problems: it's about building good business practices. A proper salary helps you:

• Plan your personal budget more effectively

• Build Social Security credits for retirement

• Maintain clean financial records

• Demonstrate professionalism to lenders and partners

The bottom line? Don't try to outsmart the IRS with clever schemes or arbitrary rules you found online. Do your homework, set a reasonable salary based on actual market data, document your decision, and run proper payroll.

If you're unsure about any of this, it's worth investing in professional help. A qualified accountant can help you navigate these requirements and set up systems that keep you compliant while maximizing your tax benefits.

Remember, the S corp election is a powerful tax strategy, but like any powerful tool, it needs to be used correctly. Pay yourself properly, keep good records, and enjoy the tax savings that come with doing things the right way.