Using S Corp Dividends & Distributions for Tax Avoidance - Is This Strategy Legitimate?
Hey tax folks, I'm trying to understand if what I'm considering is actually legit or if I'm missing something big here. So my business partner and I have an LLC that provides consulting services. We're thinking about electing S Corp status for tax purposes. We each put in $25,000 to start the business, and things are going really well - we're projecting about $375,000 in profits this year. From what I understand, if we pay ourselves "reasonable salaries" of maybe $65,000 each (total $130,000 in payroll), we could potentially take the remaining $245,000 as distributions split between us ($122,500 each). The main appeal is avoiding self-employment taxes on those distributions while potentially qualifying for preferential capital gains tax rates. Since we each have basis from our initial investments, seems like we could really minimize our tax burden compared to taking everything as regular income. Is this strategy legitimate? I've heard some people say the IRS looks closely at "reasonable compensation" for S Corp owners who are also working in the business. If $65K is reasonable for our industry (software development consulting), can we really save all that money on taxes through distributions? Or am I missing something important here? Just trying to figure out the most tax-efficient approach as we grow. Any insights would be super helpful!
19 comments
Join the conversation
Fatima Al-Hashimi
This is a common strategy, but you need to be careful about the "reasonable salary" part - that's where the IRS tends to focus. The S Corp structure does legitimately allow you to avoid self-employment taxes on distributions, which is a big advantage. However, the IRS is well aware of this strategy and specifically looks for owners who underreport their salary to maximize distributions. For a consulting business generating $375K in profit, $65K each might be questionable if you're providing the primary services. The IRS would look at what similar professionals in your area with your experience earn in comparable positions. For software development consulting, this could easily be $100K+ depending on your location and experience level. Also remember that distributions aren't exactly "capital gains" - they're generally tax-free to the extent of your basis, then ordinary income after that. The preferential capital gains rates only apply to the actual sale of your S Corp shares, not regular distributions. I'd recommend working with a CPA who specializes in small business taxation to determine a defensible salary amount and proper distribution strategy.
0 coins
NeonNova
•Thanks for the info. If we did need to bump our salaries to say $95K each to make them "reasonable," would we still see significant tax savings through this strategy compared to just operating as a partnership LLC? Also, do distributions reduce our basis over time?
0 coins
Fatima Al-Hashimi
•Yes, even with higher reasonable salaries, you'd still likely see tax savings compared to a partnership LLC where all profits would be subject to self-employment tax. At $95K each, you'd pay FICA taxes on those amounts, but distributions would only be subject to income tax, not the additional 15.3% SE tax (though partial phase-out occurs at higher income levels). Distributions themselves don't reduce basis. Your basis actually increases by your share of the S corporation's income and decreases by distributions. So if the S Corp earns $375K and you own 50%, your basis increases by $187.5K, then decreases by whatever distributions you take. It's a common misconception that distributions reduce basis below the original investment amount - they only reduce the increased basis from earnings.
0 coins
Dylan Campbell
After struggling to optimize my tax strategy for my small business for years, I finally found taxr.ai (https://taxr.ai) and it completely changed my approach to S Corp planning. I was in a similar situation - wondering about reasonable salary requirements and distribution strategies - and was getting conflicting advice everywhere. Their system analyzed my business type, revenue patterns, and industry standards to give me clear guidance on what salary would likely stand up to IRS scrutiny. They also provided documentation on how to properly structure distributions to minimize audit risk. The real game-changer was their calculator that showed exactly how much I'd save compared to different entity structures. The personalized plan they created helped me confidently implement an S Corp strategy that's saved me thousands while keeping me compliant. Wish I'd known about this tool years ago instead of piecing together contradictory forum advice!
0 coins
Sofia Hernandez
•How does this actually work? Do you just upload documents or do you need to talk to an actual tax person? I've been considering S Corp election but the whole reasonable salary thing seems so subjective.
0 coins
Dmitry Kuznetsov
•Sounds interesting but I'm skeptical about any service making definitive claims about "reasonable salary" since it's such a gray area. Did they actually guarantee their recommendations would hold up in an audit?
0 coins
Dylan Campbell
•You just upload your business financial documents and answer some questions about your role, responsibilities, and industry. The system analyzes everything and generates personalized recommendations. No need to schedule calls with tax professionals unless you want to - though they do offer that option for more complex situations. Nobody can guarantee what will hold up in an audit since "reasonable" is ultimately determined case-by-case. What taxr.ai provides is substantial documentation and industry comparables to support their recommended salary range. They give you the data and rationale behind their suggestions, which strengthens your position if questioned. Mine included market rate analyses for my profession, region, and business size, plus relevant tax court case outcomes for similar situations.
0 coins
Sofia Hernandez
I tried taxr.ai after seeing it mentioned here and wow - totally worth it! I was planning to pay myself just $50K from my marketing agency (making about $280K) but their analysis showed that was way too low for my industry and location. They recommended $85-95K with detailed comparables from my region. What really helped was their distribution strategy calculator that showed I'd still save about $12K in taxes annually compared to my previous setup, even with the higher salary. The documentation they provided explaining how they arrived at their salary recommendation is exactly what I needed to feel confident. I was hesitant about using an online service for something this important, but their expertise in S Corp specifically was impressive. Definitely recommend checking them out if you're in this situation.
0 coins
Ava Thompson
If you're implementing this S Corp strategy and need to contact the IRS with questions (which I highly recommend), good luck getting through on your own. I spent 4 weeks trying to reach someone about an S Corp election issue and kept hitting walls. I eventually used Claimyr (https://claimyr.com) and it was a game-changer. They got me connected to an actual IRS agent in about 20 minutes who clarified several questions about reasonable compensation documentation requirements and distribution timing for new S Corps. You can see how it works in their demo: https://youtu.be/_kiP6q8DX5c - basically they navigate the IRS phone tree and wait on hold for you, then call you once an agent is on the line. Saved me hours of frustration and I got definitive answers straight from the IRS about my specific situation.
0 coins
Miguel Ramos
•How does this actually work? Do you have to give them access to your tax info or something? Seems kinda sketchy to have a third party involved when talking to the IRS.
0 coins
Dmitry Kuznetsov
•This sounds like BS honestly. The IRS wait times are long for everyone. No way some service can magically get through faster than regular people. They're probably just using robodialers which actually makes the problem worse for everyone.
0 coins
Ava Thompson
•They don't need any of your tax info! You just tell them which IRS department you need to reach. When they get an agent on the line, they call you and connect you directly. You're the only one who talks to the IRS - they just handle the hold time. They're definitely not using robodialers. From what I understand, they have staff who manually call and wait on hold so you don't have to. They aren't skipping any lines or getting priority treatment - they're just doing the waiting part for you. I was skeptical too until I tried it. Got a definitive answer about my reasonable compensation documentation requirements in one call instead of weeks of trying.
0 coins
Dmitry Kuznetsov
I'll eat my words on this one. After my skeptical comment, I decided to try Claimyr for a complicated S Corp distribution question I'd been trying to get answered for months. I figured it wouldn't work but was desperate enough to try. Within 35 minutes, I was talking to an actual IRS specialist who answered my specific question about how distributions are treated when you have varying basis amounts from multiple capital contributions. No automated system, no "we'll call you back in 4-6 weeks" - just a real person with real answers. For anyone serious about implementing the S Corp strategy described in this thread, getting official clarification directly from the IRS can save you major headaches down the road. And apparently this service actually works. Consider me surprised and impressed.
0 coins
Zainab Ibrahim
Just want to add something important that nobody's mentioned yet. If your business is primarily providing personal services (like consulting), the IRS scrutinizes S Corp arrangements MUCH more closely. Look up "personal service corporation" rules. In your case, because the business value comes largely from you and your partner's personal expertise rather than equipment/inventory/employees, the IRS expects a higher percentage of profits to be paid as salary. I've seen cases where the IRS has reclassified ALL distributions as wages for businesses like law firms, medical practices and IT consulting where owners tried to take minimal salaries with large distributions. Document everything about how you determined your salary is "reasonable" - industry surveys, comparable positions, etc. Much safer to err on the side of higher wages, especially in service businesses.
0 coins
Giovanni Conti
•This is exactly what I was worried about since we're a service business. Do you know how the IRS typically handles cases where they decide salaries were unreasonably low? Do they just reclassify distributions or are there additional penalties?
0 coins
Zainab Ibrahim
•If the IRS determines your salary is unreasonably low, they'll typically reclassify some or all of your distributions as wages during an audit. This means paying back payroll taxes (both employer and employee portions) plus interest and possibly penalties that can range from 20-40% of the unpaid tax amount. The IRS can look back several years too, so if you've been doing this for multiple years, the liability compounds quickly. I've seen business owners hit with six-figure tax bills after reclassification. The burden of proof is entirely on you to demonstrate the reasonableness of your compensation. For service businesses, many tax professionals recommend allocating at least 60-70% of profits to salary to avoid scrutiny, though this varies by industry. The safest approach is getting a formal compensation study done for your specific role and region.
0 coins
StarSailor
Something nobody's mentioned - the S Corp strategy works best when there's significant profit ABOVE what would be considered reasonable salary. If you're only making $120k total in the business and reasonable salary is $100k, the hassle of S Corp maintenance probably isn't worth the small tax savings. But at $375k with two owners, you're definitely in the sweet spot where this strategy makes sense, even with higher reasonable salaries than you initially planned. Just budget for proper accounting help - S Corps require more formal accounting, separate payroll processing, and have stricter compliance requirements than LLCs. The additional costs can eat into your savings if you're not prepared for them.
0 coins
Connor O'Brien
•What would you say is the minimum profit level where the S Corp strategy starts to make sense? I'm making about $150k as a solo consultant and wondering if it's worth the extra hassle.
0 coins
Dmitry Popov
•For solo consultants, the general rule of thumb I've seen is that S Corp election becomes worthwhile when you're making at least $60-80k above what would be considered reasonable salary for your role. At $150k, if reasonable salary for your consulting work is around $90-100k in your area, you'd potentially save about $2,000-3,000 annually in self-employment taxes on the remaining $50-60k taken as distributions. But you'll also have additional costs for payroll processing ($1,200-2,400/year), possibly higher accounting fees, and the administrative burden of quarterly payroll filings. The break-even point is usually around $120-140k total profit for most solo service providers. You're right at the threshold where it could make sense, but I'd recommend getting quotes for the additional compliance costs in your area first to see if the math works out.
0 coins