As an S corporation owner, you can receive compensation through corporate distributions and payroll. If you receive a distribution, your S corporation does not withhold payroll taxes on the amount. If you draw a salary or receive a paycheck, your S corporation must withhold federal taxes, Social Security and Medicare from your gross pay. It might seem that taking distributions instead of paychecks could avoid the expense of payroll taxes, but the IRS says and the tax courts have upheld that you cannot avoid payroll taxes by reclassifying your pay as a distribution.

Tax-Free Distributions

Some types of distributions are tax-free under the U.S. tax code. If your S corporation has no profit or loss for the tax year, the distribution is tax-free as long as the amount does not exceed your stock basis. Your stock basis is the amount of cash or property you contributed to your S corporation. For S corporations that have a profit or loss, the distribution is tax-free as long as the amount does not exceed the balance in the accumulated adjustments account. An accumulated adjustments account holds the income that your S corporation earned from previous years that has been taxed but not yet distributed to shareholders.

Reasonable Payroll

The IRS expects your job description to match your compensation. The IRS uses salary information compiled by third parties such as ERI, Economic Resource Inc., as a standard for employee compensation. For example, the information in ERI’s Executive Compensation Assessor & Survey is derived from payroll comparisons based on similar companies in the same industry located in the same geographic area. The IRS will look at the number of hours you work, and your duties, responsibilities, education and training to confirm that your salary reflects your job performance.

Distributions vs. Payroll

If you receive overly high distributions, especially if your paycheck is unusually low, the IRS will reclassify the excess distribution as payroll. The IRS will take the position that you deliberately tried to avoid payroll taxes by inflating your distribution and understating your payroll. As a result, your S corporation will owe payroll taxes on the excess distribution along with late payment and reporting penalties.

Distributions vs. Capital Gains

Your distributions may be taxed as capital gains even though the IRS does not reclassify any portion as payroll. Your distribution remains tax-free as long as the amount does not exceed your stock basis. The distribution amount that exceeds your basis is taxed as a capital gain. You must report the capital gain on Schedule D and carry that amount over to your individual 1040 income tax return. This may increase your tax liability if you do not have a capital loss to offset the gain.