S Corp Payroll: What is It and How Does it Work?

Operating your business as an S corporation can be one of the smartest tax moves you can make. By strategically structuring income, you can potentially reduce your tax bill by thousands each year. But there’s a catch: the IRS requires that shareholder-employees of an S corp pay themselves a “reasonable salary.” Missteps can occur when determining your reasonable compensation, leading to back taxes, penalties, or even an audit.

This guide breaks down how S corp payroll works, what “reasonable compensation” really means, and how to set up payroll the right way from the start. By following these steps, you’ll protect your business, unlock substantial tax advantages, and project credibility to prospective investors and lenders.

Key Highlights

• S corp owner-employees must split income between salary (subject to payroll tax) and distributions (not subject to self-employment tax).

• The IRS requires a “reasonable salary” for shareholder-employees, based on factors like role, hours, experience, and industry standards.

• Documenting salary decisions—such as job descriptions, market data, and CPA studies—is essential in the event of an audit notice.

• Avoid shortcuts like the “60/40 rule”; the IRS does not recognize them and tends to trigger audits.

• Running payroll properly means setting up registrations, withholding taxes, and issuing W-2, Wage and Tax Statements, on a regular schedule.

• Professional payroll support from a full-service provider like 1-800Accountant, America's leading virtual accounting firm, simplifies compliance and reduces risk.

The Core S Corp Advantage: Salary vs. Distributions

As an S corp owner, you wear two hats: employee and shareholder. This dual role affects your compensation.

Understanding your employee salary

Your salary is the portion of compensation for the work you perform. It must be “reasonable” and is subject to standard payroll taxes, including Social Security and Medicare. These taxes fund programs such as retirement and healthcare benefits, but they also contribute to a combined FICA tax obligation of 15.3%.

Understanding your owner distributions

Distributions represent a return on your investment as the business owner. Unlike wages, they are not subject to self-employment tax, which typically leads to significant tax savings and is one of the most popular S corp features. However, distributions are only allowed if your business is profitable and you have sufficient basis in your corporation.

Salary vs. Distribution Tax Impact

Striking the right balance between these two forms of income is the foundation of S corp tax efficiency.

The Most Important Rule: Determining Your Reasonable Compensation

The IRS is vigilant about owners paying themselves artificially low wages in an attempt to avoid taxes. If the IRS determines you're underpaying yourself, they can reclassify distributions as wages, resulting in penalties and back taxes.

Factors for setting a defensible salary

When determining your salary, consider:

• Roles and responsibilities: What daily tasks do you handle?

• Experience level: What expertise do you bring?

• Time commitment: How many hours per week do you work?

• Market rates: What would a similar role earn in your industry and location? (See Bureau of Labor Statistics data.)

• Business performance: Your company’s gross receipts and profitability also factor in.

Documenting this research is critical. A formal compensation file can make all the difference during an audit.

Audit-Proof Salary Documentation Checklist:

• Written job description.

• Market salary data (BLS or industry reports).

• Weekly hours worked.

• Board resolution approving salary.

• CPA salary study or memo.

Debunking dangerous myths and shortcuts

Shortcuts like the “50/50 rule” or “60/40 rule” are not recognized by the IRS in determining a reasonable salary. Courts have rejected these methods, and relying on them usually raises red flags.

IRS red flags that trigger audits

Real-world scenarios that might lead to an audit notice include: 

• Paying yourself only at year-end in a lump sum.

• Salaries that are well below industry norms.

• No payroll documentation or W-2s issued.

A Step-by-Step Guide to Running S Corp Payroll

Running payroll isn’t just writing yourself a check—it’s a formal process with strict requirements. Review this step-by-step guide to ensure an optimal S corp payroll process. 

Step 1: Complete necessary registrations

Address this step by completing the following applications and registrations.  

• Apply for an Employer Identification Number (EIN) through the IRS. It's free and only takes a few minutes to obtain. 

• Register for state-level payroll tax accounts, such as unemployment insurance (SUTA), to ensure compliance with state regulations.

Step 2: Set up a formal payroll system

You need a system with capabilities to withhold taxes, generate pay stubs, and file payroll returns. Options include:

• Do it yourself (DIY) payroll software: Cheaper, but requires managing deadlines and filings, among other tasks that require your time. 

• Full-service payroll provider: Automates filings, calculations, and payments. With 1-800Accountant's full-service payroll, filings across federal, state, and local jurisdictions are handled for you, minimizing risk.

Step 3: Pay yourself on a regular schedule

Consistency matters in payroll. Paying yourself biweekly or monthly establishes credibility. It also enables you to avoid lump-sum “salary” payments, which the IRS may see as disguised distributions. If the IRS makes this determination, you will pay more in taxes, erasing a critical advantage of operating as an S corp.   

Key payroll tax forms:

• IRS Form 941, Employer's Quarterly Federal Tax Return – Quarterly federal tax return (due April 30, July 31, Oct 31, and Jan 31).

• Form W-2 – Annual wage statement to report salary.

Regular paychecks not only reduce audit risk but also build trust with prospective lenders and investors reviewing your financial records.

Build Your Business on a Foundation of Compliance with 1-800Accountant

The S corp structure offers powerful tax savings, but those savings depend on payroll compliance. Determining reasonable compensation and keeping clean payroll records isn’t just about avoiding penalties—it’s about demonstrating that your business is professionally managed.

With 1-800Accountant’s year-round business tax advisory solution, you can work with experienced CPAs, EAs, and tax professionals who provide documented compensation studies and analysis, ensuring you’re covered in the event of an audit. Our payroll service automates filings and payments, freeing your time to focus on growing your S corporation.

Don’t rely on guesswork. Schedule a free, 30-minute consultation with a small business expert to learn how to run payroll the right way, while protecting valuable S corp tax advantages.

Frequently Asked Questions (FAQ)

What happens if I don’t pay myself a salary and only take distributions?

The IRS may reclassify your distributions as wages if you don't pay yourself a salary, potentially resulting in back taxes, penalties, and interest. This could also trigger an audit, putting your entire tax strategy at risk.

Does my business have to be profitable to pay me a salary?

Yes. You must pay yourself a reasonable salary if you are actively working in the business, even if profits are modest. Distributions, however, are only available when the business generates profit.

How do I handle health insurance premiums for myself as an S Corp owner?

Premiums paid by the S corp for more-than-2% shareholders are reported on the W-2 but can still be deductible on your personal tax return. The rules are specific, so it's best to have a CPA guide you.

Can I pay myself once a year?

No. The IRS expects payroll to be processed regularly, such as on a monthly or biweekly basis. Year-end lump payments are a red flag for reclassification.

How does the IRS check if my salary is reasonable?

The IRS compares your salary against industry standards, your role, and business performance. They may request documentation, which is why a formal compensation file is essential. There isn't an exact formula to determine what's reasonable. 

What if I underpay myself and get audited?

The IRS can reclassify distributions, issue penalties, and demand back taxes if you underpay yourself. Proper documentation and a CPA study are your best defense against questions of underpayment.

Do I need payroll if I’m the only employee?

Yes, you need to run payroll in this scenario. Even if you’re the sole owner-employee, you must run payroll with withholdings and file W-2s.

How does S corp payroll work across multiple states?

If you operate in multiple states, you must register for payroll taxes in each state and comply with varying requirements. A full-service payroll provider can handle multi-state compliance for you.