How to Structure Owner Compensation for Tax Efficiency
Owner compensation isn’t just about how much you take home – it’s about how you take it home. The way you structure your pay can have major implications for taxes, retirement planning, and even IRS scrutiny.
Whether you’re an S corporation shareholder, a partner in a partnership, or a sole proprietor, getting this right can save you money and keep you compliant.
S Corporation Owners: The Employee-Shareholder Role and Reasonable Compensation Rules
If you own an S corporation and actively work in the business, the IRS considers you to wear two hats at the same time. You are considered an employee-shareholder. This is a point that trips up a lot of S corporation owners.
Employee – You perform services for the corporation, so you must be paid W-2 wages just like any other worker. These wages are subject to income tax withholding, Social Security, and Medicare taxes.
Shareholder – You own stock in the corporation and are entitled to a share of its profits, which are paid as distributions. Distributions are not subject to payroll taxes but are reported to you on Schedule K-1 and taxed as pass-through income. Because you are considered an employee-shareholder of the S corporation, the K-1 flow-through income isn’t subject to self-employment tax.
Why the Dual Role Matters
The IRS requires you to pay yourself a reasonable salary for the work you perform. They call this “reasonable compensation”. Without this rule, owners could avoid payroll taxes entirely by taking all profits as distributions. If your wages are too low, the IRS can reclassify distributions as wages and assess back payroll taxes, penalties, and interest.
What’s Reasonable?
The Internal Revenue Code doesn’t specifically provide a formula for reasonable compensation. The IRS looks at factors such as:
Industry standards for your role
Your training and experience
Time spent working in the business
Duties performed
As an example, let’s say your S corporation earns $200,000 in net profit. You might structure your pay to include $115,000 in W-2 wages with the remaining $85,000 taken as distributions. Reasonable compensation requirements may be met along with distributing remaining profit to you, which won’t be subject to payroll tax. This split reduces payroll taxes while staying compliant.
Tip: Use a compensation survey or industry data to document how you set your salary. This creates a paper trail if the IRS ever questions it.
Why S Corporations Treat Owners as Employees (and Partnerships Don’t)
S corporations are still corporations under the law – a separate legal entity from their owners. If you work for the corporation, you’re legally its employee, even though you own 100% of the stock. This is why the IRS enforces payroll and “reasonable compensation” rules – to ensure Social Security and Medicare taxes are collected on earned income.
Partnerships, on the other hand, are treated as an aggregate of the partners for tax purposes. Partners are considered self-employed, not employees, and can’t be treated as both a partner and an employee for the same work. Instead, they’re compensated through guaranteed payments and/or draws, with self-employment tax applied at the partner-level.
Partnerships: Draws vs. Guaranteed Payments
In a partnership or multi-member LLC taxed as a partnership, owner pay comes in two main forms as we touched on above.
1. Draws – Taking a distribution isn’t a taxable transaction when withdrawn, since you’re taxed on your share of profit whether you take it or not. The idea here is that a distribution is taken when there is net profit. Draws reduce your partner capital account - they aren't deductible by the partnership.
2. Guaranteed Payments – Fixed amounts paid to partners regardless of profit. These are taxable income to the partner and deductible by the partnership. Therefore, partners don’t take wages via payroll where payroll taxes are paid at the partnership-level. Instead, the partner is required to pay the tax at the partner-level.
Planning Considerations
Guaranteed payments ensure a steady cash flow for active partners, but they trigger self-employment tax.
Draws can be more flexible but depend on available profit and capital.
W-2 Wages vs. K-1 Income: Understanding the Mix
W-2 wages are earned income reported on Form W-2 and subject to payroll taxes.
K-1 income (from an S corporation or partnership) is pass-through income reported on Schedule K-1.
Key differences:
W-2 wages count toward certain retirement plan contribution limits and Social Security credits.
S-corporation K-1 income is not subject to payroll tax and doesn’t count towards Social Security credits, but it is still subject to income tax.
Partnership K-1 income for active partners is generally subject to self-employment tax and counts towards Social Security credits (unless exempted under specific rules).
Compensation Planning for Retirement Contributions
Your Retirement plan limits – and your ability to maximize tax-deferred savings – are directly tied to how you pay yourself.
Let’s run through a few examples:
S Corp 401(k) – Your employee deferrals are based on W-2 wages, so a low salary means lower deferral limits, even if K-1 income is high.
Partnership SEP IRA – Contributions are based on net self-employment income after deducting the contribution itself and half of self-employment income.
Solo 401(k) – Combines employee deferrals based on earned income and employer profit-sharing as a percentage of net income or W-2 wages.
Work with a qualified financial advisor to learn the numerous options for retirement planning.
Tip: If retirement savings is a priority, plan your salary/guaranteed payment levels to maximize allowable contributions.
Bringing It All Together: Strategic Considerations
When deciding how to structure your compensation, think beyond the current tax bill:
Short-term: What mix of wages, guaranteed payments, and distributions minimizes current payroll and self-employment tax while meeting IRS rules?
Long-term: How does your pay structure affect retirement contributions, Social Security credits, and future business valuation?
Documentation: Keep clear records of how you determine pay – this is your best defense in an audit.
Bottom Line: Structuring owner compensation for tax efficiency is a balancing act between compliance, cash flow, and long-term planning. The right mix can reduce taxes, improve retirement savings, and keep you out of trouble with the IRS.