Tax Planning for S Corporations: Salary, Distributions and Basis
By SimplyCPA · 11 October 2026
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- Reasonable salary: Shareholder-employees must be paid reasonable wages before taking distributions; the IRS can reclassify distributions as wages.
- Payroll tax trade-off: Wages bear FICA; distributions don't. But under-paying salary invites IRS challenge and can reduce the QBI deduction where W-2 wage limits apply.
- Basis planning: Losses need basis — lend money directly to the company (guarantees don't count) or contribute capital before year-end.
- Distributions: Keep them pro rata to share ownership; disproportionate distributions can threaten the one-class-of-stock rule.
- State taxes: Many states offer an elective pass-through entity tax (PTET) paid by the company, which the IRS has said is deductible at entity level.
1. Reasonable compensation
An S corporation shareholder who works in the business must receive reasonable compensation before non-wage distributions. The IRS looks at factors such as training and experience, duties, time devoted, what comparable businesses pay for similar services, and the company's dividend history. Courts have repeatedly reclassified distributions as wages where shareholder-officers took little or no salary.
2. The payroll tax trade-off
Example: An S corporation earns $200,000 before paying its sole shareholder. Option A: $120,000 salary + $80,000 distribution. Option B: $60,000 salary + $140,000 distribution.
Option B saves FICA (employer and employee combined 15.3% up to the Social Security wage base) on $60,000 — about $9,180 — if $60,000 is defensible as reasonable compensation for the work performed. If it isn't, the IRS can reclassify, with penalties and interest.
3. Interaction with the QBI deduction
The Section 199A qualified business income deduction (made permanent by the OBBBA) is up to 20% of QBI. Shareholder wages are not QBI, so a lower salary raises QBI — but above the income thresholds, the deduction is limited by 50% of W-2 wages paid by the business (or 25% of wages plus 2.5% of qualified property). Cutting salary too far can reduce the deduction.
4. Building basis to use losses
- Lend money directly to the S corporation to create debt basis. A guarantee of a bank loan doesn't create basis until the shareholder actually pays on it.
- Back-to-back loans (the shareholder borrows and re-lends to the company) can create basis if they're bona fide.
- Remember the ordering: income increases basis first, distributions reduce it before losses — so a year-end distribution can reduce the losses a shareholder can deduct.
5. Distributions
- Make distributions pro rata by shares. Unequal distributions may be treated as evidence of a second class of stock (although governing-provision rules give some protection).
- If the company has earnings and profits from C corporation years, distributions beyond the accumulated adjustments account are taxable dividends. An election to distribute E&P first can be useful in a low-rate year.
- Distributing appreciated property triggers corporate-level gain that flows through to all shareholders.
6. Health insurance for more-than-2% shareholders
Premiums paid by the S corporation for a more-than-2% shareholder are included in that shareholder's W-2 wages (not subject to FICA if paid under a plan for employees), and the shareholder can usually deduct them above the line as self-employed health insurance.
7. Pass-through entity taxes (PTET)
Individual state and local tax deductions are capped. Many states let S corporations and partnerships elect to pay state income tax at the entity level. In Notice 2020-75, the IRS said such payments are deductible by the entity in computing its non-separately stated income — effectively bypassing the individual cap.
Start with S corporation basis and loss limits.