Owner Pay Strategy: W-2 Salary vs. Distributions

One of the most common questions we get from S-Corp owners: "How much should I pay myself?"

The answer affects your tax bill, cash flow, and IRS audit risk. Get it wrong, and you could overpay taxes by thousands—or face penalties for paying yourself too little.

The Two Ways to Pay Yourself (S-Corp)

When you own an S-Corp, you have two options for taking money out:

1. W-2 Salary

• Subject to payroll taxes (15.3% up to wage base)
• Required for anyone doing "meaningful work" in the business
• Deductible business expense
• Reported on W-2

2. Distributions

• NOT subject to payroll taxes
• Reported on K-1
• Only available after paying reasonable salary
• Limited by equity basis

The tax savings come from taking as much as possible as distributions instead of salary—but there's a catch.

The "Reasonable Compensation" Requirement

The IRS rule: You must pay yourself a reasonable salary for the services you provide before taking distributions.

Pay yourself too little salary, and the IRS may reclassify distributions as wages (plus penalties and interest).

What Is "Reasonable"?

The IRS considers:

1. Training and experience
2. Duties and responsibilities
3. Time devoted to business
4. Dividend history
5. Payments to non-shareholder employees
6. Timing and manner of paying bonuses
7. What comparable businesses pay for similar services
8. Compensation agreements
9. Use of a formula to determine compensation

General benchmarks (service businesses):

• 40-60% of net income as salary
• Remaining 40-60% as distributions

Example:

• Net income: $150K
• Reasonable salary: $70-90K
• Distributions: $60-80K

WA vs. OR: Different Strategies

Washington (No State Income Tax)

Strategy: Minimize salary, maximize distributions

• Distributions are not subject to state tax (because there is none)
• Pure federal SE tax savings
• More aggressive salary/distribution split works

Example:

• Net income: $150K
• Salary: $70K (47%)
• Distributions: $80K (53%)
• State tax on distributions: $0

Oregon (State Income Tax)

Strategy: Still beneficial, but less dramatic savings

• Distributions are subject to OR income tax (9.9% top rate)
• Federal SE tax savings still significant
• Slightly more conservative split recommended

Example:

• Net income: $150K
• Salary: $80K (53%)
• Distributions: $70K (47%)
• State tax on distributions: ~$6,900

Bottom line: S-Corp still worth it in Oregon above ~$80K net income

Industry-Specific Guidance

Different industries have different "reasonable" benchmarks:

Consultants / Solopreneurs

• High-skill, personal services
• Salary typically 50-70% of net income
• IRS scrutiny is higher (harder to argue distributions are "return on capital")

Contractors / Trades

• Capital-intensive business
• Salary can be 40-50% of net income
• Equipment and crew justify more distributions

Healthcare Providers

• Professional services
• Salary typically 60-70%
• State-specific rules may apply

Agencies / Creative Firms

• Mix of owner labor and team leverage
• Salary typically 40-60%
• Depends on how much you're "doing the work" vs. managing

Real-World Examples

Example 1: Too Aggressive (Audit Risk)

Client: Solo consultant, $200K net income Their approach: $40K salary (20%), $160K distributions Problem: $40K is way too low for someone doing all the work IRS risk: High—likely reclassification

Better approach:

• Salary: $100K (50%)
• Distributions: $100K (50%)
• Tax savings: still ~$15K/year vs. sole prop

Example 2: Too Conservative (Overpaying Tax)

Client: Product-based business, $180K net income Their approach: $120K salary (67%), $60K distributions Problem: Overpaying payroll taxes

Better approach:

• Salary: $85K (47%)
• Distributions: $95K (53%)
• Additional savings: ~$5K/year

Example 3: Just Right

Client: Creative agency, $250K net income, 2 other employees Approach: $110K salary (44%), $140K distributions (56%) Rationale:

• Comparable agency employees make $90-120K
• Owner does meaningful work but team delivers too
• Mix feels defensible

Result: IRS-defensible position, maximized tax savings

How to Calculate Your Reasonable Salary

Step 1: Research comparable positions

• Check salary.com, Glassdoor, PayScale
• Ask "What would I pay someone to do my job?"
• Consider location (PNW vs. national average)

Step 2: Document your rationale

• Keep notes on how you arrived at your salary
• Track comparable positions
• Document your actual duties

Step 3: Adjust annually

• As profit grows, salary should grow (but not 1:1)
• Review each December for the following year

Step 4: Get professional input

• This is where a CPA adds real value
• We model different scenarios and recommend a defensible number

Common Mistakes

1. Zero salary, all distributions

Problem: Instant IRS red flag Solution: Always take some salary if doing meaningful work

2. Paying minimum wage

Problem: Not reasonable for skilled professionals Solution: Pay what you'd pay someone else for your role

3. Never adjusting salary

Problem: As business grows, $50K salary becomes obviously unreasonable Solution: Review and adjust annually

4. No documentation

Problem: Can't defend your position in an audit Solution: Keep notes on how you set your salary

Cash Flow Considerations

Salary requires:

• Payroll processing (quarterly or monthly)
• Payroll tax deposits (immediate)
• Consistent cash flow to meet payroll

Distributions are flexible:

• Take them when cash flow allows
• No minimum required
• Can vary by quarter

Strategy for lumpy cash flow:

• Set salary lower (but still reasonable)
• Take larger distributions in high-cash months

Multi-Owner S-Corps

Special considerations:

• Each owner must take reasonable salary for their work
• Distributions can be split per ownership %
• One owner taking all distributions while others take salary = audit risk

Example: 50/50 partners

• Partner A: Does sales, strategy (40 hrs/week)
  • Salary: $80K
• Partner B: Does operations, delivery (40 hrs/week)
  • Salary: $80K
• Remaining profit: Split 50/50 as distributions

When to Change Your Strategy

Increase salary if:

• Net income growing significantly
• Taking on more responsibilities
• Comparable positions show higher pay

Consider distributions if:

• Cash flow is lumpy (salary is fixed, distributions flexible)
• Tax savings justify the complexity
• You have capital basis to support distributions

Getting Help

DIY risks:

• Under/overpaying yourself
• Poor documentation
• Audit vulnerability

Working with a CPA:

• We model different scenarios
• Provide written documentation of rationale
• Monitor IRS guidance changes
• Adjust as your business evolves

Cost: Included in monthly accounting or available as standalone analysis ($500)

The Bottom Line

Optimal owner pay strategy:

1. Pay yourself a reasonable salary (40-60% of net income, depending on role)
2. Take remaining profit as distributions
3. Document your rationale
4. Adjust annually as business grows

Tax savings: $8K-20K+ per year for most S-Corps above $100K profit

The sweet spot: Aggressive enough to save taxes, conservative enough to avoid audit risk

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