1120-S: Understanding Officer W-2 Salary vs. Distribution Impact on S-Corp Tax Return

Thanks for this clear explanation. Quick follow-up question - if the scenario changed and the business had expenses of $30,000 (beyond the officer compensation), would that just further reduce the amount going to Retained Earnings? And does the officer need to take a salary if the business isn't profitable yet?

Yes, any additional business expenses would further reduce both the taxable income and the amount going to Retained Earnings. If you had $30,000 in additional expenses, your RE increase would be $27,000 instead of $57,000. Regarding officer salary in unprofitable businesses - this is a common question. Even in unprofitable businesses, the IRS expects officers who provide services to receive "reasonable compensation." However, the "reasonable" amount may be lower in struggling businesses. Some startups do defer compensation until profitability, but this creates other potential issues. If the officer is performing substantial services, some salary is generally advisable even during unprofitable periods.

I've heard about tax document review tools but was skeptical. How detailed is the analysis? Does it just give generic advice or does it actually review the specific numbers on your return?

I'm curious about this too. My accountant charges me $95 every time I ask a question about my S-Corp. Would something like this help me double-check their work without racking up more hourly fees?

The analysis is surprisingly detailed. It doesn't just give generic advice - it actually reviews your specific numbers and calculations. For instance, it caught that my officer compensation to distribution ratio was out of typical ranges for my industry, which could trigger IRS scrutiny. It also identified inconsistencies between my Schedule L, K-1, and Form 1120-S that I didn't notice. Regarding using it to check your accountant's work, absolutely. I actually use it now before meetings with my CPA to make sure I understand everything first. It helps me ask better questions and verify that everything looks right. You can upload whatever documents you have - even drafts or prior year returns - and get insights into potential issues.

Wait, there's a service that waits on hold with the IRS for you? How does that even work? Does it actually connect you with the right department?

This sounds like a scam. Why would anyone pay for something like this when you can just call the IRS directly? I'm pretty skeptical about whether they actually get you through faster than just calling yourself.

It works by using a combination of automated systems and live operators who know the optimal times to call and which options to select. When an actual IRS agent picks up, they connect you immediately. And yes, they get you to the right department - you specify what you need help with when setting it up. The benefit isn't that they have some "secret" way to cut the line - it's that they handle the waiting for you. Instead of being stuck on hold for hours, not knowing when someone will pick up, you can continue working and just answer when they call you with an agent ready. For business owners and tax preparers, that time savings is hugely valuable during tax season.

Do you have a general guideline for reasonable distribution-to-salary ratios? I've heard some accountants say distributions shouldn't exceed salary, but I'm not sure if that's an actual rule or just being conservative.

There's no fixed ratio requirement in the tax code, so any "rule of thumb" is just that - a guideline, not a legal requirement. What matters is that the salary amount is reasonable for the services provided based on factors like experience, duties, time committed, industry standards, and business size. That said, when distributions significantly exceed salary, it can draw more attention. I generally advise clients to keep distributions at or below salary amounts when possible, especially in highly profitable businesses. But every situation is unique - a capital-intensive business with large equipment investments might legitimately have higher distributions to help owners recoup their capital, while a service business should typically have higher salary ratios.

Technically, S-Corp distributions should be proportional to ownership percentages to avoid creating a second class of stock, which could invalidate your S election. If you need to distribute differently, there are workarounds like adjusting officer compensation for those who actively work in the business.

This is exactly what I was looking for! Thank you for breaking down the Schedule L treatment so clearly. I was getting confused about whether the officer salary was already "baked into" the net income calculation or if I needed to make separate adjustments. Your point about the IRS computers automatically checking the retained earnings relationships is really helpful - I didn't realize they had automated checks for that. Is there a specific tolerance they use, or do even small discrepancies trigger correspondence? Also, regarding the shareholder basis tracking - should I be maintaining separate records for this, or is there a standard form/schedule that tracks basis changes year over year? This is my first time dealing with S-Corp basis and I want to make sure I'm documenting everything properly for future reference.

Great follow-up questions! The IRS matching is pretty sensitive - even small discrepancies can trigger automated correspondence, so it's worth being precise. They cross-reference your current year beginning retained earnings against your prior year ending retained earnings, and any mismatch usually generates a letter asking for explanation. For shareholder basis tracking, there's no required IRS form, but you absolutely should maintain detailed records. I recommend creating a simple spreadsheet that tracks: beginning basis, plus/minus income/loss allocations, minus distributions, minus non-deductible expenses, plus additional capital contributions. Update it annually when you complete the K-1. Many tax software programs have basis tracking worksheets, but don't rely solely on those since they can get corrupted or lost between years. Keep your own permanent records because basis calculations become critical if the shareholder ever sells their stock, takes losses that exceed basis, or if the S-election is terminated. The IRS doesn't track this for you, so poor record-keeping can cost you significantly down the road. Also, make sure your basis calculations include any loans the shareholder makes to the corporation - those increase basis and are often overlooked.

This is incredibly helpful, especially the tip about thinking of Schedule L in terms of "what happened to the company's money" - that really clarifies the logic behind the entries! Your point about the K-1 Line 1 showing $83,000 makes perfect sense now that I understand the officer compensation is already deducted from ordinary income. I'm definitely taking your advice about documenting the officer salary justification seriously. I've been reading about some recent IRS cases where they've reclassified distributions as wages, and the penalties can be brutal. Do you have any specific resources or industry salary databases you'd recommend for benchmarking reasonable compensation? I want to make sure I'm using credible sources that would hold up under scrutiny. Also, one quick clarification - when you mention the K-1 ordinary income should tie back to 1120-S net income, are you referring to Line 21 (ordinary business income) on the 1120-S? I want to make sure I'm cross-checking the right lines between the forms. Thanks for the encouragement about it getting easier - as a newcomer to S-Corp taxation, it definitely feels overwhelming at first, but posts like yours are helping me see how the big picture fits together!