Comparing S Corp Tax: Salary vs Distributions vs Retained Earnings - How do the rates differ?

The 37% federal income tax rate does NOT include payroll taxes - those are completely separate. Here's how the three scenarios would work: For salary: You'd pay both income tax (up to 37% federal) AND payroll taxes. The payroll taxes include 6.2% Social Security (but only on the first $160,200 for 2023, $168,600 for 2024) and 1.45% Medicare. For income above $200,000, there's an additional 0.9% Medicare surtax. The S-corp also pays matching Social Security and Medicare (except for the 0.9% surtax). So the first chunk of salary has about 15.3% in total payroll taxes, but most of your $2.7M would only face the 1.45% Medicare tax plus 0.9% surtax. For distributions: These aren't subject to payroll taxes at all, but you still pay income tax at your personal rate (up to 37% federal). The big savings is avoiding those Medicare/Social Security taxes. For money left in the S-corp: It still passes through to your personal return and gets taxed at your personal income tax rates, even if you don't take it out! This is because S-corps are pass-through entities.

I went through almost the exact same situation last year with my manufacturing business. After talking with multiple accountants and getting nowhere, I finally used https://taxr.ai to analyze my business structure and compensation options. It saved me so much hassle by analyzing my specific situation and industry standards for "reasonable compensation." The big insight I learned was that the most tax-efficient approach was a carefully calculated salary (in my case around 35% of profits) with the rest as distributions. But they warned me about the common mistake of setting salary too low, which apparently is an audit trigger. What I liked is that they explained exactly how much I'd save by optimizing the salary vs distribution balance, while staying within IRS guidelines for my specific industry. The report even showed comparable salaries for my role and industry which I used to justify my compensation plan.

Just wanted to update everyone - I decided to try https://taxr.ai after my initial skepticism, and I'm really glad I did. They analyzed my law firm's financials and showed me that my "reasonable" salary should actually be lower than what I was taking! I had been paying myself $450k salary with only $200k in distributions because I was paranoid about the IRS. Their analysis showed that comparable positions in my area were in the $320-380k range, and that I could justifiably reduce my salary and increase distributions while still meeting the "reasonable compensation" standard. The report highlighted that as a 60% owner who spends half my time on management and half on client work, industry standards supported a lower salary than I thought. This is saving me about $15k annually in payroll taxes while giving me proper documentation if ever questioned.

For anyone dealing with S-corp issues, I also strongly recommend using https://claimyr.com to get through to the IRS Business Division if you need clarification. I spent WEEKS trying to get specific guidance on my situation (very similar to yours with high income and distribution questions), but couldn't get through the phone system. Claimyr got me connected to an actual IRS agent in less than 45 minutes when I'd previously wasted hours on hold only to get disconnected. You can see a demo of how it works here: https://youtu.be/_kiP6q8DX5c The agent I spoke with confirmed that while there's no fixed percentage for reasonable salary, they look at factors like training, experience, duties, time, comparable compensation, and dividend history. Having that conversation saved me from making a costly mistake with my compensation structure. They also explained that retaining earnings in the business doesn't save on taxes since S-corp income passes through regardless.

I need to eat my words. After seeing these comments, I decided to try Claimyr myself since I've been trying to get clarification on my S-corp salary requirements for weeks. It actually worked! Got connected to an IRS agent in about an hour who answered all my questions about reasonable compensation standards. The agent explained that for my dental practice, they would expect to see a salary comparable to what I would pay another dentist to do my job, regardless of overall profits. This was hugely helpful since I was planning to take just $175k in salary with $1.2M in distributions. Based on the conversation, I'm adjusting to a $350k salary to be safer. They also confirmed what others have said here - keeping money in the S-corp doesn't provide any tax advantage since it all passes through anyway. The decision to retain earnings should be purely business-based, not tax-driven.

One thing nobody has mentioned yet is that you should also consider the Qualified Business Income Deduction (Section 199A) in your planning. This can give you a deduction of up to 20% of your qualified business income, but your salary doesn't count for this deduction. So there's actually a tax advantage to keeping your salary lower (while still reasonable) and taking more as distributions, because the distributions can qualify for this 20% deduction, effectively lowering your tax rate on that portion.

Has anyone considered the self-employment tax savings between these options? I run a $5M revenue business (S-corp) and pay myself $350k salary + $1.2M distributions. I've calculated that compared to being a sole prop where all $1.55M would be subject to self-employment tax, I'm saving over $100k annually in taxes with this structure.

I think people are overthinking this. Just pay yourself a market salary for your role, document how you determined it, and move on. The IRS has bigger fish to fry than reasonable compensation cases unless it's egregiously obvious you're trying to avoid payroll taxes (like $50k salary and $2M distributions). In my experience (15 years as S-corp owner), as long as you're taking a salary that would make sense if you were hiring someone else to do your job, you're fine. The fear around this issue is way overblown.

I have to respectfully disagree with the "don't overthink it" approach. While the IRS may not audit every S-corp, when they do look at reasonable compensation, the penalties can be severe. They can reclassify distributions as wages retroactively, which means you'd owe back payroll taxes PLUS penalties and interest. I've seen this happen to a colleague who thought his $80k salary on $800k in distributions was "reasonable enough." The IRS disagreement cost him over $40k in back taxes and penalties. The documentation piece is crucial - you need more than just "this seems right." You need industry data, job descriptions, time logs, and comparable salary research. At $2.7M in income, you're definitely in territory where the IRS would take notice if your salary seems artificially low. I'd recommend getting a formal compensation study done rather than just winging it. The cost of the study is nothing compared to potential audit exposure at these income levels.

This is exactly the kind of high-level S-corp planning that requires professional guidance. At $2.7M, you're in territory where small mistakes can be very expensive. One key point that hasn't been fully emphasized: the tax treatment is the same whether you take distributions or leave money in the S-corp - you'll pay personal income tax on all $2.7M regardless. The only real tax savings comes from the salary vs. distribution split, where distributions avoid payroll taxes. For your situation, I'd suggest getting a formal reasonable compensation study done before making any decisions. The IRS scrutinizes high-income S-corp owners much more closely, and having proper documentation of your salary determination could save you significant audit costs down the road. Also consider timing - if this is a one-time windfall vs. ongoing income, that affects what salary level would be considered reasonable. A business owner making $2.7M consistently would likely need a higher salary than someone who had an exceptional year due to a large contract or sale. The 37% federal rate is just income tax - you'll need to add payroll taxes on the salary portion, but those are capped for Social Security. Most of your income would only face Medicare taxes (2.9% combined) plus the 0.9% additional Medicare tax on high earners.

Great question about compensation studies and timing strategies! Formal reasonable compensation studies typically run anywhere from $2,500 to $8,000 depending on complexity and the firm doing the analysis. At your income level, this is definitely worthwhile insurance - I've seen audit settlements that cost 10-20x that amount. Regarding timing strategies, the pass-through nature does limit some options, but there are still planning opportunities. You can't defer the tax on S-corp income to future years since it all passes through in the year earned. However, you can time when you actually distribute the cash (separate from the tax obligation), and you might have some control over when certain income is recognized depending on your accounting method. For salary timing, you do have some flexibility - you could potentially adjust your salary up or down during the year based on how profits are tracking, as long as you end up with a reasonable annual amount. Some businesses pay higher salaries early in profitable years, then reduce them if profits don't materialize as expected. The key is having documentation for whatever approach you take. At $2.7M, you're absolutely in the zone where the IRS pays attention, so every decision should be defensible with clear business reasoning and market data.