Yes, an S corp owner who works for the business must pay themselves a "reasonable salary" via payroll, subject to payroll taxes, before taking remaining profits as distributions, which are not subject to payroll taxes; failing to pay a reasonable salary is a major red flag for the IRS and can lead to penalties, as the agency requires fair compensation for services rendered, comparable to market rates.
You may or may not have heard of the S Corp Salary 60/40 rule. The guideline encourages setting reasonable compensation between 60% and 40% of the business's net profits. The IRS does not set this guideline.
The short answer is "no", as long as the S Corp makes no distribution to the owner-employee to avoid payroll taxes.
Key Takeaways
Choose the Right Method Based on Your Business Structure: Sole proprietors and partners typically use owner's draws, while S and C Corp owners must take a salary to meet IRS rules.
Like a C Corp, S Corp shareholders who perform duties for the company must also be on payroll for the work they do. In most cases, this means they will receive both wages, which are subject to payroll taxes, and dividends, which are not. It should be noted, however, that dividends are subject to income tax.
S Corp salary is W-2 compensation subject to payroll taxes (Social Security, Medicare), while distributions are leftover profits paid to owners (shareholders) that are not subject to payroll taxes, offering significant tax savings, but you must pay yourself a reasonable salary first, as excessive distributions disguised as salary can trigger IRS penalties. The key difference is tax treatment, with distributions saving on employment taxes, but the IRS scrutinizes this, often looking for structures that minimize salary to avoid FICA taxes, so paying a reasonable salary (often cited as 40-60% of total comp, but not a fixed rule) is crucial for compliance.
S-Corp: Owners must take income through a salary. Since the corporation is a separate legal entity, owners can only take distributions, not owner's draws. Distributions must be limited in scope and not in lieu of a regular salary. C-Corp: Owners must take income through a salary.
As a limited company director, you have much greater control and choice over how you pay yourself, meaning you can potentially minimise the tax you pay. A sole trader would be required to take a salary and would be taxed accordingly, whereas a director could take a combination of salary and dividends.
The "2% rule" for S Corporations treats shareholders owning more than 2% of the company's stock (or voting power) differently for fringe benefits, classifying them like partners in a partnership, not regular employees; this means benefits like health insurance premiums paid by the S Corp must be included as taxable wages on their W-2, rather than being tax-free, though the shareholder can often deduct these premiums as an "above-the-line" deduction. This rule prevents them from participating in tax-advantaged Section 125 cafeteria plans, making benefits like Health FSAs unavailable on a pre-tax basis.
How do S corp owners pay themselves? Those who are both an employee and a shareholder in an S corporation generally pay themselves via distributions and a salary. The latter is necessary if the individual performs more than minor services for the business.
Taking an S Corp election allows business owners to split their income and earnings between payroll and ordinary income. Ordinary income is not subject to self-employment taxes because the income of an S Corp is generally taxed to the shareholders of the corporation rather than to the corporation itself.
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.
Putting your kids on payroll can shift income into their lower tax brackets. Wages up to the standard deduction ($15,000 in 2025) can be tax-free for the child. Tax treatment differs by entity type: LLCs avoid payroll taxes for children under 18, but S Corps and C Corps do not.
Remember that if you have an S or C Corp, you're only eligible to take a salary. For example, if you run an LLC taxed as a sole proprietorship, you can pay yourself a salary for the work you perform and also take an owner's draw from the profits.
For corporations, such as S Corps and C Corps, the owner's draw is not reported on personal tax returns. S Corps avoid double taxation by passing the income, deductions, and credits through to their shareholders, who then report the flow-through of income and losses on their personal tax returns.
Many LLC owners use a combo strategy, especially those taxed as S Corporations. The general rule of thumb? Pay yourself a reasonable salary first, then take additional profits as distributions. This way, you remain IRS-compliant while reducing payroll taxes on excess income.
A: In California, an employer cannot unilaterally change your pay structure from hourly to salary without your explicit agreement, especially if it results in lower compensation.
Taking a small director's salary topped up with regular dividends from profits is the most tax-efficient way to pay yourself through a limited company. The most tax-efficient director's salary in 2025-26 is either £5,000, £6,500, or £12,570.
The 80/20 Rule
A stripped-down version of the 50/30/20 rule, this budget advises setting aside 20% of your income for savings and using the remaining 80% for both necessities and luxuries. Some people prefer this breakdown because they don't have to differentiate between wants and needs.
This income is taxed as ordinary income on the shareholder's personal tax return. This is why it makes good sense to do S Corp distributions; because the shareholders are going to be taxed on that income whether it stays on the S Corp's books or whether it's distributed to the shareholders as ordinary income.