Taking Money Out of an S-Corp: Salary, Distributions and Basis

There are two ways money leaves an S-Corp and reaches the owner, and they are taxed differently enough that the split is the entire reason the election exists. There is also a limit on the second one that most owners have never heard of until it applies to them.

Wages for the work you do in the business. They run through payroll, carry Social Security and Medicare on both sides, appear on a W-2, and are deducted by the corporation as compensation.

The corporation must pay reasonable compensation before distributions are considered. That ordering is the rule, and inverting it — small salary, large distributions — is what draws scrutiny.

Your share of profit, taken out as an owner rather than as an employee. No payroll tax, no withholding, no W-2.

A distribution is not itself a taxable event in the normal case. You were already taxed on your share of the corporation's profit through the K-1, whether or not you took the cash. The distribution is you receiving money that has already been taxed — which is why it carries nothing further.

That is also why "I did not take any distributions so I owe no tax" is wrong, and why "I took a large distribution so I owe tax on it" is usually wrong too. The tax followed the profit, not the withdrawal.

Your stock basis is what you have invested in the corporation, adjusted every year for what has happened since. It starts with what you contributed, increases by your share of income, and decreases by your share of losses and by distributions taken.

Basis does two jobs. It caps the losses you can deduct — a loss beyond basis is suspended until basis is restored — and it determines whether a distribution is tax-free.

A distribution up to your basis is a return of your own money and is not taxed. A distribution beyond your basis is treated as a capital gain and is taxed, in a year when you may have taken the money precisely because you thought it was already taxed.

This is the trap. An owner who takes out more than the business has earned, over several years, can exceed basis without any single transaction looking unusual.

The corporation reports its own figures. Stock basis is a shareholder-level calculation reported with the personal return, and it depends on your history with the company, not the company's history.

In practice this means it goes untracked until it matters — a loss year, a large distribution, or the sale of the business. Reconstructing it years later, from bank records and old K-1s, is expensive and sometimes impossible.

Keep a running basis schedule from the first year. It is one line per year and it takes minutes when the year is fresh.

Money moved from the corporation to the shareholder and called a loan is a loan only if it behaves like one: a written note, a stated interest rate, a repayment schedule, and actual repayments.

Without those, it is a distribution — or, if the pattern suggests it is compensation for work, wages. The label in the books does not decide the question.

Loans from the shareholder to the corporation raise a different point: they create debt basis, which can support loss deductions when stock basis has run out, but only under conditions that are specific and easy to fail.

That last point is worth sitting with. An S-Corp is permitted only one class of stock, and distributions that consistently do not follow ownership percentages can be read as creating a second one. In a single-shareholder company the question does not arise. In a two-owner company where one takes more than their share, it can.