S Corp Distributions: Tax Rules You Need To Know

Let’s be honest—taxes already feel complicated enough. But throw in business ownership and suddenly you’re wading through terms like “reasonable compensation” and “S Corp distributions.” Maybe you’ve asked yourself: “Wait, do I pay payroll tax on distributions? Is this the same as dividends? Am I going to get in trouble if I do this wrong?”

You’re not alone. Many S Corp owners wrestle with the same questions. The truth is, distributions are one of the biggest benefits of choosing an S Corporation structure—but only if you follow the IRS rules carefully. Mess it up, and you could face audits, penalties, or double taxation headaches.

This article breaks it down. We’ll cover:

• How S Corp distributions really work.
• What the IRS looks for when you pay yourself.
• The difference between salary, dividends, and draws.
• Key tax rules that protect you from red flags.
• A few practical examples to tie it all together.

My goal? To help you walk away with a clearer, calmer understanding of S Corp distributions—so you can pay yourself confidently and keep more of your hard-earned money.

What Exactly Is an S Corp Distribution?

At its simplest, an S Corp distribution is money the business pays out to shareholders from profits. Unlike a paycheck, distributions aren’t treated as earned income. That means:

• They aren’t subject to Social Security and Medicare taxes (unlike wages).
• They typically flow through to your personal tax return.
• You’re taxed at your personal income tax rate, not corporate tax rates.

Think of it like this: your salary is what you’re paid for working in the business. Your distributions are what you get because you own the business.

But—and this is important—S Corp owners don’t get to skip payroll taxes entirely. The IRS requires that you pay yourself a “reasonable salary” first, before taking distributions. That’s where people get tripped up.

Salary vs. Distribution: Where the Line Gets Blurry

Let’s say your S Corp earns $120,000 in profits this year.

• If you pay yourself a $60,000 salary, you’ll owe income tax and payroll tax on that.
• If you then take a $40,000 distribution, that amount avoids payroll tax (only income tax applies).
• The remaining $20,000 stays in the business for expenses or future use.

Sounds straightforward, right? The trouble is, some owners try to outsmart the system by keeping salaries super low—like $20,000—and taking everything else as a distribution. That’s a big IRS red flag.

According to the IRS Fact Sheet 2008-25, underpaying yourself is considered tax avoidance. If they audit you, they can reclassify distributions as wages, slap you with penalties, and demand back payroll taxes.

The takeaway: distributions are powerful, but only when balanced with a fair salary.

So… What Counts as “Reasonable Compensation”?

This phrase comes straight from IRS language, but frustratingly, they don’t set a hard number. Instead, they look at:

• Industry standards – What do people in your field, with your role, typically earn?
• Duties and responsibilities – Are you the CEO doing everything, or a partial operator with limited hours?
• Experience and skills – Higher expertise usually means higher pay.
• Business size and profitability – If your company makes $500,000, a $20,000 salary will raise eyebrows.

One useful benchmark: the U.S. Bureau of Labor Statistics publishes average wages by role and industry. Many accountants use that data to help clients defend their salary decisions.

I’ll admit—it can feel a bit fuzzy. But generally, if you’re paying yourself what you’d have to pay someone else to do your job, you’re on safer ground.

Tax Treatment of S Corp Distributions

Now let’s get into the nitty-gritty of how distributions show up on your taxes.

1. Federal Income Tax

Distributions “pass through” to shareholders and show up on Schedule K-1 of your personal tax return. You’ll pay federal income tax at your regular rate.

2. Self-Employment Tax

Here’s the good news: distributions are not subject to self-employment tax. That’s the 15.3% bite that sole proprietors and partnerships usually face. This is the main tax savings perk of an S Corp.

3. State Taxes

Some states treat distributions differently. For instance, California charges an additional 1.5% S Corp tax. Others follow federal rules more closely. Always check your state’s treatment before assuming you’re in the clear.

4. Ordering Rules

If your company has accumulated earnings and profits (from when it was a C Corp), distributions might be taxed as dividends instead of pass-through income. This is rare but worth noting.

Common Mistakes Owners Make

Even well-intentioned business owners slip up here. The most frequent pitfalls include:

• Skipping payroll altogether – Taking only distributions and no salary.
• Overdrawing – Taking more money than the company actually made, which can create shareholder loan problems.
• Not withholding taxes – Forgetting that distributions don’t automatically cover your tax liability.
• Ignoring basis rules – If you take more in distributions than your ownership basis, those extra amounts can become taxable capital gains.

One IRS audit study showed that more than half of S Corps examined had issues with officer compensation. That’s a pretty striking number, and it shows how closely this area is watched.

How to Stay Compliant (Without Driving Yourself Crazy)

The key here isn’t perfection—it’s reasonableness and documentation. A few practical steps:

• Set up payroll correctly. Use a system like Gusto, QuickBooks Payroll, or even a professional service to run regular paychecks.
• Decide on distributions quarterly or annually. Don’t pull cash every week in random amounts—it looks messy and harder to defend.
• Document your logic. Keep notes on why you set your salary at a certain level (industry averages, BLS data, etc.).
• Don’t forget estimated taxes. Distributions don’t withhold, so plan for quarterly payments to avoid penalties.
• Work with a CPA. Especially one familiar with S Corp tax planning, since the rules get nuanced quickly.

And here’s something worth keeping in mind: the IRS often looks at officer compensation and distributions during audits. If that thought makes you nervous, don’t worry—there are smart ways to prepare. Check out our guide on How To Prepare For An IRS Audit Through Strategic Planning? for practical tips on staying ahead of any potential red flags.

If you’re in a place like Texas, you might even consider tax planning services in Fort Worth, TX—just having local experts who understand state-specific nuances can save you serious stress.

Wrapping It All Up

S Corp distributions can feel confusing, but here’s the short version:

• Pay yourself a reasonable salary first.
• Take distributions out of profits, not just available cash.
• Keep good records to defend your choices.
• Plan for taxes—distributions aren’t a free ride.

Handled wisely, distributions are one of the best perks of the S Corp structure. They let you reduce payroll taxes and still enjoy the rewards of your business success.

If this article helped clear things up, consider bookmarking it for tax season, or share it with a fellow business owner who’s also navigating S Corp rules. Sometimes, just having the right knowledge upfront makes the difference between peace of mind and a stressful IRS letter.