Do I pay tax when I take money out of my S-Corp?

If you’ve formed an S-Corporation, you’ve probably run into a familiar question: How do I take money out of my business, and what does that mean for taxes?

S-Corps offer real tax advantages. You avoid corporate tax, reduce self-employment tax, and gain more control over how income flows to your personal return. But those benefits come with responsibilities, especially when it comes to how you pay yourself. 

This article breaks down how money flows out of an S-Corp, what each method means for your taxes, and how to avoid common mistakes that could lead to penalties, audits, or extra tax bills. 

Will I owe tax when I take money out? 

Taking money out of your S-Corp doesn’t necessarily mean you’ll owe more tax. That’s one of the biggest misconceptions S-Corp owners run into. And it can lead to expensive mistakes if you’re not careful. 

S-Corps are pass-through entities, meaning the business doesn’t pay federal income tax. Instead, the profits flow through to you and show up on your personal return, typically from Form 1120S. Whether you leave the money in the business or take it out, you’re taxed on your share of the income either way. 

Why does it matter how you take money out? 

Because the method affects whether there’s additional tax. If you take a distribution, that money is usually not taxed again as long as you have enough basis. Your basis is your investment in the business: what you’ve contributed, plus accumulated profits, minus prior losses and distributions. If your distribution stays within your basis, it’s tax-free. If it goes over, you could owe capital gains tax on the excess. 

Here’s how that looks in practice: 

Imagine you start your marketing consultancy as an S-Corp with an initial investment of $50,000. This becomes your starting basis. 

Year 1:  

• Your S-Corp earns $120,000 in profits 
• These profits flow through to your personal tax return (you pay income tax on them) 
• Your basis increases to $170,000 ($50,000 initial + $120,000 profits) 
• You take $70,000 in distributions for personal use 
• Year-end basis: $100,000 ($170,000 - $70,000) 

Year 2: 

• Business has a tough year with only $30,000 in profits 
• Your basis increases to $130,000 ($100,000 + $30,000) 
• You take $150,000 in distributions 
• This exceeds your basis by $20,000 ($150,000 - $130,000) 
• Result: $20,000 is subject to capital gains tax 

This example shows why tracking your basis is critical. Without proper tracking, you might inadvertently trigger capital gains taxes on distributions that exceed your basis.  

But here's where many S-Corp owners run into trouble: if you're also not paying yourself a reasonable salary, you could be flagging yourself for an IRS audit. The IRS expects owner-employees to be on payroll if they're actively working in the business, and skipping this step is one of the most common red flags they look for. Publication 535 lays it out clearly.  

Distributions may feel tax-efficient, but without a salary, they can still raise flags with the IRS. Next, we’ll break down what the IRS considers a reasonable salary, and why that number matters. 

What is a reasonable salary?  

The IRS doesn't give a specific number for what your salary should be as an S-Corp owner. Instead, they give you a rule: if you're doing meaningful work for the company, you must pay yourself a reasonable salary before taking distributions. 

But what does "reasonable" actually mean? 

It’s not a guess, and it’s definitely not just whatever number keeps your payroll taxes down. The IRS expects your salary to reflect the market rate for your services. That includes factors like your role, your experience, what others in similar positions earn, how much time you spend in the business, and the size and profitability of the company. 

In the 2005 Watson v. United States case, the court ruled that a CPA who paid himself only $24,000 while taking over $200,000 in distributions owed tens of thousands in back payroll taxes. After winning that case, the IRS started paying closer attention to S-Corp owners who set their salaries suspiciously low. 

Here's how the IRS sees it: no salary means no pass on payroll taxes. If you're not paying yourself properly, expect them to reclassify your distributions. 

And if you're thinking about skipping payroll altogether and paying yourself as a contractor, there's even more at stake. 

To learn more about how to calculate a reasonable salary, and how to document it, check out our Reasonable Compensation guide. 

Could I pay myself as a contractor instead?  

Some S-Corp owners try to keep things simple by skipping payroll and issuing themselves 1099 payments. It might feel easier in the short term, but the IRS sees this as a mistake. 

As the owner of an S-Corporation who actively works in the business, the IRS requires you to be treated as a W-2 employee, not a contractor. That means being on the payroll and paying yourself a salary that actually reflects the work you're doing. 

If you pay yourself as a contractor, you're sidestepping employment tax obligations and misclassifying your role. And while that might save you time in the short term, it opens the door to bigger problems down the line. 

Not only would you be responsible for self-employment taxes at the individual level, but your business could also owe back payroll taxes, penalties, and interest for failing to withhold and remit what was required. 

This kind of misclassification is one of the quickest ways to draw IRS attention. They’ve made it clear that owner-employees must be paid through payroll. 

If you want to protect your S-Corp benefits and keep your distributions audit-proof, avoid paying yourself as a contractor. It may seem like a shortcut, but it usually creates more risk than reward.  

So, what are your options if you're not ready to take a salary or a distribution but still need to borrow funds from the business? That’s where a properly structured shareholder loan can help bridge the gap. 

Can my S-Corp loan me money?  

Yes, your S-Corporation can loan you money. But whether it's treated as a legitimate loan or a disguised distribution comes down to how you structure it.  

The IRS reviews shareholder loans closely. To be treated as a true loan, there must be clear intent to repay: documented terms, market-rate interest, and a repayment schedule. The IRS spells out their expectations in Publication 535: without proper terms and documentation, it's not a real loan in their eyes.  

If those pieces are missing, the IRS may reclassify the funds as a distribution, or even as compensation. That reclassification could trigger payroll tax obligations, income tax, or capital gains depending on your basis. 

And importantly, loans can’t replace a reasonable salary. If you’re actively working in the business, the IRS still expects you to be on payroll. 

Shareholder loans can be a helpful tool when used sparingly and documented properly. But without the right structure, they can create more problems than they solve. Think of it as borrowing from a lender: the paperwork, interest, and repayment terms must be in place.   

Payment Method Comparison at a Glance

The Bottom Line 

Taking money out of your S-Corporation isn’t one-size-fits-all, but it also doesn’t have to be complicated. The most tax-efficient strategy usually follows a simple order: 

• Pay yourself a reasonable W-2 salary 
• Take distributions within your basis 
• Use shareholder loans for short-term needs, with proper documentation 

Getting this balance right can reduce your tax liability, keep you in good standing with the IRS, and give you more control over your business finances. 

If you’re unsure whether your current strategy holds up, or you’re just starting to think through your options, we can help. Schedule a free consultation with DiMercurio Advisors and get a clear, compliant plan for taking money out of your business. We’ll help you avoid costly errors and make the most of your S-Corp status.