Trap 2 · The split · From Chapter 9
Distributions vs Salary: How the S-Corp Split Works
S-corp owners take money two ways: W-2 salary, which carries payroll tax, and distributions of remaining profit, which don't. The split is legal only when the salary is reasonable for the work performed — distributions first and salary second is the pattern examinations target.
How the split works
Salary runs through payroll with Social Security and Medicare tax. Distributions come from remaining profit — income tax was already paid on it via the K-1, so no second income tax, and no payroll tax at all.
The basis limit
Distributions beyond stock and debt basis generally become capital gain. Track basis yearly — the return needs it, and the exam will ask.
The audit pattern
No payroll plus large distributions is the classic trigger. The IRS doesn't argue theory; it recharacterizes dollars and bills the payroll tax that should have run.
Trap questions, answered
- Do distributions avoid income tax too?
- No — S-corp profit is taxed to shareholders yearly whether distributed or not. Distributions avoid payroll tax, not income tax.
- What if I distribute more than my basis?
- The excess is generally capital gain. Track stock and debt basis yearly — the return needs it.
- Can I skip payroll entirely?
- Only if you perform no services — rare for an owner-operator. No payroll plus large distributions is the classic exam trigger.
From the practice: S-corp vs LLC, compared
The other traps: Reasonable Compensation · S Election Eligibility · Built-In Gains Tax · Late S Election Relief