S‑Corp Salary, Distributions, Draws, and Basis — How They Work Together

For S corporations, four concepts interact in important ways: owner salary (wages paid to shareholder‑officers), shareholder distributions (cash or property paid with respect to stock), “owner draws” (usually a colloquial reference to distributions or shareholder loan activity), and each shareholder’s stock/debt basis. Understanding how they relate is essential to stay compliant, avoid payroll tax and reclassification risks, and correctly determine the taxability of distributions and the deductibility of pass‑through losses. At a high level:

• Salary to a shareholder‑officer is W‑2 wages subject to employment tax rules and the “reasonable compensation” standard; it is not a distribution and does not directly reduce stock basis (though it reduces S‑corporation income, which indirectly affects basis) Paying yourself | IRS; S corporations | IRS; Treas. Reg. § 1.1367-1.

• Distributions reduce a shareholder’s stock basis and may be taxable if they exceed basis or if the S corporation has accumulated earnings and profits (AE&P) from C‑corp years; the ordering rules hinge on the accumulated adjustments account (AAA) and AE&P IRC § 1368; Treas. Reg. § 1.1368-1; Treas. Reg. § 1.1368-2.

• “Draws” are not a special tax category for S corporations; in practice a “draw” is generally either a shareholder distribution or an advance/repayment on a bona fide shareholder loan. The tax treatment depends on proper classification and documentation (wage vs. distribution vs. loan) and the shareholder’s basis S corporation stock and debt basis | IRS (Form 7203 & instructions).

• Basis (stock and debt) drives both the taxability of distributions and the deductibility of losses; basis adjustments follow specific ordering rules and are separately tracked for stock and bona fide shareholder loans IRC § 1367; Treas. Reg. § 1.1367-1; Treas. Reg. § 1.1367-2; Instructions for Form 7203.

Owner Salary (Shareholder‑Officer Compensation)

• S corporation officers are generally employees. When they perform services and receive (or are entitled to) compensation, those payments are wages subject to employment taxes and withholding. Paying “reasonable compensation” commensurate with duties is required; the IRS can reclassify non‑wage payments as wages if compensation is unreasonably low Paying yourself | IRS; S corporations | IRS.

• Salary is a corporate deduction that reduces S‑corporation income passing through to shareholders. Because stock basis increases by the shareholder’s share of pass‑through income and decreases for pass‑through losses and other items, wages reduce the amount of income increasing basis, but wages themselves are not distributions and do not separately reduce basis Treas. Reg. § 1.1367-1(b)–(c).

• Salary is reported on Form W‑2 to the shareholder‑employee, and the S corporation files applicable payroll returns (for example, Forms 941/940). Salary is not reported as a “distribution” on Schedule K‑1 (Form 1120‑S) S corporations | IRS; General Instructions for Forms W‑2 and W‑3.

Shareholder Distributions (Cash or Property)

• Non‑dividend distributions. If the S corporation has no AE&P at year‑end, distributions are generally tax‑free to the extent of the shareholder’s stock basis; any excess over stock basis is taxed as a capital gain. Stock basis is reduced (but not below zero) by the distribution IRC § 1368(b); Treas. Reg. § 1.1367-1(c)(1)(ii); S corporation stock and debt basis | IRS (Form 7203 & instructions).

• Distributions when AE&P exists. If the S corporation has AE&P (e.g., from prior C‑corp years), distributions follow a statutory order: first from AAA (non‑dividend, basis reduction), then as a dividend to the extent of AE&P, and any remainder as a non‑dividend distribution (basis reduction) with capital gain to the extent it exceeds basis. Corporations may elect to alter the default order (with shareholder consents), but absent an election, the statutory stacking applies IRC § 1368(c); Treas. Reg. § 1.1368-1(d)–(f); Treas. Reg. § 1.1368-2.

• Property distributions. When appreciated property is distributed, the S corporation recognizes gain as if the property were sold at fair market value; the gain passes through to shareholders and increases AAA. The distribution amount to the shareholder is generally FMV (reduced by liabilities assumed), and the shareholder takes FMV basis in the property. Losses on property distributions are generally disallowed Treas. Reg. § 1.1368-1(d).

• Reporting. Non‑dividend distributions are reported to shareholders on Schedule K‑1 (Form 1120‑S), box 16, code D, and reduce stock basis. Dividends (distributions out of AE&P) are reported on Form 1099‑DIV and do not reduce stock basis; a distribution exceeding basis is capital gain 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S); S corporation stock and debt basis | IRS (Form 7203 & instructions).

“Owner Draws”: What They Are (and Aren’t)
“Draw” is a bookkeeping or colloquial term, not a tax status. In an S corporation, owner payments are either:

• W‑2 wages (compensation for services), or

• Shareholder distributions with respect to stock, or

• Loan transactions (advances to or repayments to the shareholder).
  Classifying a draw correctly is critical because each category has different tax and basis consequences. Misclassifying wages as distributions risks IRS reclassification (and payroll tax assessments); misclassifying a distribution as a loan (or vice versa) undermines basis tracking and can cause unintended gain or disallowed losses Paying yourself | IRS; Treas. Reg. § 1.1367-2.

Shareholder Basis: The Keystone

• Two kinds of basis. Each shareholder tracks stock basis and (if applicable) basis in bona fide shareholder loans to the S corporation. Both determine the taxability of distributions and the deductibility of pass‑through losses IRC § 1367(b)(2); Treas. Reg. § 1.1367-2; Instructions for Form 7203.

• Basis adjustments and ordering. Stock basis is increased by pass‑through income (including tax‑exempt income) and certain excess depletion; decreased (but not below zero) by: (1) distributions, (2) non‑deductible, non‑capital expenses, and (3) losses and deductions. Ordering generally is: increase for income; then decrease for distributions; then decrease for non‑deductible expenses; then decrease for losses/deductions. If distributions exceed stock basis, the excess is capital gain. Disallowed losses carry forward and are re‑tested when basis is restored IRC § 1367(a), (b); Treas. Reg. § 1.1367-1(f); 2024 Shareholder’s Instructions for Schedule K‑1.

• Debt basis nuances. If stock basis is exhausted, disallowed losses may reduce basis in shareholder debt (direct loans). Later “net increases” must first restore reduced debt basis before increasing stock basis; repayment of reduced‑basis debt can trigger taxable gain to the shareholder. Merely guaranteeing corporate debt does not create debt basis—basis arises only to the extent the shareholder makes payment under the guarantee IRC § 1367(b)(2); Treas. Reg. § 1.1367-2(c)–(d); 2024 Shareholder’s Instructions for Schedule K‑1; Instructions for Form 7203.

• Basis tracking and Form 7203. Shareholders generally must file Form 7203 when they claim losses potentially limited by basis, receive non‑dividend distributions, dispose of S‑corporation stock, or receive loan repayments. Accurate, year‑by‑year basis schedules are crucial because they affect current and future tax results Instructions for Form 7203.

AAA and AE&P: What’s Under the Hood

• Accumulated Adjustments Account (AAA). AAA is a corporate‑level memorandum account tracking previously taxed S‑corporation income. It increases for pass‑through income and decreases for items such as losses, non‑deductible expenses, and distributions sourced from AAA. When an S corporation with AE&P makes distributions, AAA determines how much is non‑dividend (basis reduction) versus taxable dividend Treas. Reg. § 1.1368-2(a).

• Ordering when AE&P exists. By default, distributions are: (1) out of AAA (non‑dividend, basis reduction), (2) then from AE&P as a dividend, (3) then any remainder as non‑dividend (basis reduction) with capital gain to the extent distributions exceed stock basis. Elections can be made (with consent of affected shareholders) to change sourcing order or to make a deemed dividend under specified rules IRC § 1368(c); Treas. Reg. § 1.1368-1(f).

Putting It Together: Typical Interactions and Pitfalls

• Low salary, high “draws.” Paying a shareholder‑officer little or no salary while taking large draws risks IRS reclassification of distributions as wages (with back payroll taxes and penalties). Ensure officer compensation is reasonable based on services and market data; only amounts paid truly “with respect to stock” belong in distributions Paying yourself | IRS.

• Distributions vs. basis. Before making distributions, confirm each shareholder’s stock basis. Non‑dividend distributions in excess of basis trigger immediate capital gain; large year‑end distributions after losses can easily create unexpected gain if basis was depleted IRC § 1368(b); S corporation stock and debt basis | IRS (Form 7203 & instructions).

• Loans and repayments. Properly document shareholder loans (promissory notes, stated interest, repayment terms). If loan basis was reduced by prior losses, later repayments can cause taxable gain; conversely, advances can provide debt basis supporting loss deductions, but guarantees alone do not create basis Treas. Reg. § 1.1367-2(b)–(d); 2024 Shareholder’s Instructions for Schedule K‑1; Instructions for Form 7203.

• Property distributions. Distributing appreciated property can create corporate‑level gain with shareholder‑level consequences; consider modeling alternatives (e.g., selling property and distributing cash) to clarify economics and reporting Treas. Reg. § 1.1368-1(d).

Reporting Summary

• Wages: Report on Form W‑2; subject to employment taxes; wages reduce pass‑through income (indirectly affecting stock basis) S corporations | IRS; General Instructions for Forms W‑2 and W‑3.

• Non‑dividend distributions: Report on Schedule K‑1 (Form 1120‑S), box 16, code D; reduce stock basis; taxable as capital gain to the extent exceeding basis 2024 Shareholder’s Instructions for Schedule K‑1; S corporation stock and debt basis | IRS (Form 7203 & instructions).

• Dividends (from AE&P): Report on Form 1099‑DIV; do not reduce stock basis; taxable under dividend rules IRC § 1368(c); Treas. Reg. § 1.1368-1(d).

• Basis tracking: Maintain stock/debt basis schedules and file Form 7203 when required (e.g., losses limited by basis, non‑dividend distributions, stock dispositions, loan repayments) Instructions for Form 7203.

Practical Takeaways

• Pay shareholder‑officers a documented, reasonable wage for services; do not substitute distributions for compensation Paying yourself | IRS.

• Classify “draws” correctly—as wages, distributions, or loan advances/repayments—and keep precise records to avoid reclassification or basis errors S corporation stock and debt basis | IRS (Form 7203 & instructions).

• Before any distribution, confirm each shareholder’s stock basis and the corporation’s AE&P/AAA positions; apply the ordering rules to prevent unintended dividends or capital gains IRC § 1368; Treas. Reg. § 1.1368-1; Treas. Reg. § 1.1368-2.

• Track basis annually using the statutory ordering rules; use Form 7203 where applicable. Remember: non‑dividend distributions reduce stock basis before losses; disallowed losses carry forward until basis is restored Treas. Reg. § 1.1367-1(f); Instructions for Form 7203.

• Model property distributions carefully—corporate gain can arise even when no cash is received; consider alternatives and timing Treas. Reg. § 1.1368-1(d).

This essay is not tax advice. Always consult a qualified tax professional for your specific situation.