According to the Small Business Administration, the United States has over 34.7 million small businesses. Sole proprietorships make up 86.3% of small businesses without employees. However, for companies with employees, more than half (53%) are S Corporations (S Corps). S Corps are popular because they offer tax benefits and limited liability legal protections.
What you’ll learn
What you’ll learn
Updated: May 8, 2025
Key takeaways
- An S Corp is a business structure combining some of the best features of a C-corporation and a partnership
- S Corp owners can pay themselves a salary (which is subject to payroll taxes) and distributions (which are not subject to payroll taxes)
- Shareholder-employees are required to pay themselves a “reasonable salary” per the IRS
- Establishing the optimal balance between salary and distributions can reduce your tax liability
However, S Corps must follow different payroll tax rules than those governing other types of business entities. In this guide, we’ll discuss how the S Corp structure works, considerations relating to paying yourself, and how to set up the optimal payroll framework.
Understanding S Corp structure
Simply put, an S corporation combines the benefits of a C corporation and a partnership. It is ideal for business owners who want to minimize tax liabilities while protecting their personal assets from creditors. Like a C corporation, with an S corporation, you are not held personally liable for the business’s debts, and like a partnership, business profits or losses pass-through to your personal tax return.
Many entrepreneurs find themselves puzzled about their employment status when they establish an S Corporation. To get some clarity on the subject, we spoke to Tom Brock, a licensed CPA and CFA charterholder with over a decade of experience helping small businesses optimize their operations.
Am I self-employed if I own an S Corp?
“For tax purposes, an S Corp owner is not considered to be self-employed in the same way as an owner of a sole proprietorship or partnership. An S Corp owner is characterized as a shareholder, and, if he or she works in the business, is also a W-2 employee.
An S Corp shareholder-employee is required to pay himself or herself a reasonable salary, which is subject to payroll taxes. Any residual profit in the business can be taken as distributions, and these amounts are not subject to payroll taxes – a key tax advantage of the S Corp structure.
While an S Corp owner is not considered to be self-employed for tax purposes, he or she may be viewed as self-employed in other contexts, including when seeking debt financing and applying for health insurance.”
— Tom Brock, CFA, CPA
Now that we better understand the basics, let’s find out how this structure varies from others that entrepreneurs consider.
Differences between S Corps and other business entities
S Corps are different from other business entities. For example, when considering an S Corp vs. LLC, it’s important to understand that both are pass-through entities, but LLCs have fewer ownership restrictions.
| Business structure | Ownership | Liability | Taxes |
| Sole proprietorship | One only | Sole proprietor personally liable for business debts |
|
| Partnerships | Two or more | Unlimited personal liability, unless structured as a limited partnership or limited liability partnership |
|
| Limited liability company (LLC) | One or more | Owners not personally liable |
|
| C Corp | One or more | Owners not personally liable |
|
| S Corp |
|
Owners not personally liable |
|
Tax implications for S Corp owners
As an S Corp owner, you get special tax perks. Unlike C corporation owners, who must pay taxes twice — once as a company and again as individuals — S Corps owners only pay taxes once, at the personal level.
Another benefit is how you get paid. As an S Corp owner, you’re both a shareholder and an employee. So, you can earn money from your business in two ways: by getting a salary and by receiving distributions. Your salary gets taxed for Social Security and Medicare, but your distributions, which are profits extracted from your business, aren’t subject to those taxes.
You can save money on payroll taxes by taking a relatively small salary and a relatively large amount of distributions. However, the IRS requires you to take a “reasonable salary” as a shareholder-employee. This limits the extent to which you can minimize your payroll tax obligations.
Determining a reasonable salary for S Corp owners
What does “reasonable salary” mean, and how is it determined? The phrase is somewhat vague, but the IRS is very strict when it comes to enforcement. Fortunately, some guidelines exist.
Factors influencing reasonable salary
According to the IRS, S Corps must pay their shareholder-employees a fair salary. This means your pay should be about the same as what you’d earn for a similar job elsewhere. The factors the agency considers are as follows:
- Training and experience levels
- The job functions performed
- The amount of time spent and the amount of effort exerted in executing the job functions
- Peer group compensation norms
- Pertinent S Corp compensation agreements
Assessing all of these factors can be cumbersome. To expedite things, many S Corp shareholder-employees embrace a 60/40 allocation rule to split their income as follows: 60% salary and 40% distributions. This is a fairly conservative allocation that does not raise much IRS scrutiny, but some individuals prefer a more aggressive stance.
What is the 50/50 rule for S Corp salary?
Many favor a 50/50 allocation rule, which results in an even split between salary and distributions. For highly profitable S Corps, the allocation can reflect an even higher portion of distributions. The key is justifying the framework. So how do you go about this? Once more we spoke with our subject matter expert, Tom Brock.
“This means documenting how the salary component aligns with market norms. Use third-party compensation data, such as industry salary surveys or reports from the US Bureau of Labor Statistics, to establish a defensible baseline. Also, consider internal factors, such as the number of hours worked and the complexity of the duties performed.
Additionally, strive to maintain clear documentation (i.e., corporate resolutions, HR manuals, and board meeting minutes) outlining how compensation decisions are made. This way, if the IRS ever challenges the salary/distributions allocation, you can point to a rational, data-driven approach, rather than to an arbitrary allocation rule.”
— Tom Brock, CFA, CPA
IRS guidelines and penalties for non-compliance
S Corp owners need to adhere to the IRS’ “reasonable salary” guidelines. If you pay yourself too little, you could end up in hot water. The IRS could scrutinize your tax returns more aggressively, and this could result in audits, interest charges, and penalties. The IRS might even make you pay extra taxes if they determine a portion of your distributions should have been counted as salary.
How does S Corp payroll management work?
With any business structure, there are regulatory requirements and tax obligations to keep in mind. For an S Corp, addressing payroll-related compliance issues is especially important. Once more, we caught up with our subject matter expert Tom Brock to elaborate on this subject.
Do I need to run payroll with an S Corp?
“If you are an S Corp shareholder who is involved in day-to-day operations or provides ongoing services to the business, you are generally required to pay yourself a “reasonable salary.”
This means you must withhold and remit payroll taxes such as Social Security, Medicare, and federal (and possibly state) income taxes. You must also file pertinent tax returns. If you have multiple employees, the administrative effort is compounded.”
— Tom Brock, CFA, CPA
The takeaway? These calculations can be complex and often take time to get right. “This is why many S Corps elect to leverage an automated payroll system, such as OnPay, to streamline their workflows and reduce compliance-related risk,” explains Tom. If you’re considering using a provider to keep your numbers on track, we’ve also compiled a resource that compares the best rated payroll services to save you time on research.
Good to know
If you’re the sole, passive shareholder of an S Corp that does not employ any individuals, running payroll is not necessary. However, most small S Corps are owner-operated, and most large S Corps have employees. In each of these scenarios, running payroll is a critical part of ensuring compliance with the IRS.
Compliance with IRS regulations
Paying yourself in accordance with S Corp guidelines can help you avoid IRS scrutiny and unnecessary interest and penalty charges. Doing so entails keeping adequate records, correctly reporting salaries and distributions, and filing your tax documents on time. The IRS forms that S Corps need to file are as follows:
- Form 941, Employer’s Quarterly Federal Tax Return: Quarterly payroll and income tax reports to the IRS
- Form W-2, Wage and Tax Statement: Wage and tax statements for each employee, including yourself as the owner
- Form 1120-S, U.S. Income Tax Return for an S Corporation: Annual income tax return for S Corps
Can an S Corp deduct payroll taxes?
An S Corp can deduct the employer portions of payroll taxes (i.e., Social Security, Medicare taxes, and federal/state unemployment taxes) as business expenses. These employer-paid payroll taxes are fully deductible on the S Corp’s annual income tax return (Form 1120-S). Essentially, the deductions reduce the S Corp’s taxable income, which, in turn, reduces the pass-through income reported on the entity’s shareholders’ individual tax returns.
Approaching tax benefits
In addition to enabling a business to minimize its payroll taxes, an S Corp can offer other tax benefits, including deductions for health insurance plan contributions, retirement plan contributions, and employee perks.
That said, trade-offs exist. For example, reducing your salary means you will pay less in S Corp payroll taxes; however, doing so limits the amount you can contribute to your retirement accounts. It makes good business sense to consult a tax professional to optimize your S Corp’s overall tax benefits and remain compliant with tax laws.
Balancing salary and distributions
As discussed above, the ability to structure a strategic compensation program (salary vs. distributions) is a key advantage of the S Corp organizational structure. This feature enables a shareholder to minimize his or her payroll tax obligations, but care must be taken to implement a framework that is IRS compliant. Once more, we caught up with Tom for his take.
Is it better to take distributions or salary?
“As an S Corp owner, you should take a sensible mix of distributions and salary. If you only take distributions and skip a salary, the IRS could reclassify those distributions as wages and assess back taxes and penalties. Conversely, if you only take salary and no distributions, you’re likely to incur an unnecessarily high amount of payroll taxes.
Strive to establish a fair salary that is in line with peer group norms for the kind of work you do. Then, take all other compensation in the form of distributions. This will enable you to remain compliant with the IRS and minimize the amount of payroll taxes incurred.”
Advantages of optimizing the salary-distribution mix
When you optimize your salary and distribution mix, you reduce the amount of unnecessary taxes. If you take too much salary and not enough distributions, you might pay more in self-employment taxes than necessary.
Impact on Social Security and Medicare taxes
As an S Corp owner, you pay self-employment tax, which is both the employer and employee parts of Social Security and Medicare. This can be a big chunk, about 15.3% of your earnings.
If you lower your salary, you might pay less tax now, but it could mean getting reduced Social Security benefits when you retire. Social Security benefits are calculated based on your salary, not distributions.
A tax professional can help you figure out the optimal mix of salary and distributions for your business. He or she can ensure you’re not paying more taxes than necessary, while also thinking about your future benefits.
Steps for setting up S Corp payroll
If you are worried about setting up payroll for an S Corp, there are plenty of resources at your disposal. To get started, follow the steps below.
- Establish a reasonable salary: As the owner, you need to choose a salary for yourself based on what similar jobs pay and what you do for the company.
- Calculate and pay payroll taxes: Withhold and pay your payroll taxes, including Social Security, Medicare, unemployment insurance, and other local and state taxes.
- File quarterly payroll tax forms: Fill out Form 941 for the federal taxes and payroll tax payments. Some states may have extra forms you need to fill out.
- File annual tax returns: Fill out Form W-2 for employee wages and Form 940 for federal unemployment taxes. Give W-2s to employees, and file them with the IRS. Use Form 1120-S to file your S Corp’s annual taxes.
S Corp payroll: Balancing opportunity with obligation
Many entrepreneurs choose S Corps for their tax benefits and limited liability protections. This structure, however, requires close attention to tax obligations, including proper handling of Social Security, Medicare, and income taxes. A good payroll software can streamline these processes, freeing you to focus on growing your business. Whatever structure you choose, our team is here to help and ready to answer your questions.
Take a tour to see how easy payroll can be.
Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.