What is the difference between distributions and payroll?
When managing a small business or working within a corporation, understanding how owners and employees get paid is essential. Two terms often confused are distributions and payroll. While both involve money leaving a business to benefit individuals, they are distinct in function, tax treatment, and legal requirements.
In this post, we break down the core differences between distributions and payroll—what they are, who they apply to, and the potential risks of misclassifying them.
Understanding Payroll
Payroll is the process of compensating employees for their labor. This includes regular salaries, hourly wages, bonuses, and commissions.
Key Features:
Paid on a scheduled basis (e.g., bi-weekly or monthly)
Subject to payroll taxes (Social Security, Medicare, federal/state income tax)
Requires employer tax contributions
Must be reported on W-2 forms
Considered a deductible business expense
If you're an employee of your own S Corporation or C Corporation, and you work in the business, the IRS requires that you receive a reasonable salary through payroll before taking any distributions.
Failure to follow this rule can trigger an IRS audit and potential penalties.
Understanding Distributions
Distributions are profits withdrawn from the business by its owners or shareholders. Unlike payroll, these are not considered compensation for services and are not subject to payroll taxes.
Key Features:
Only available to business owners or shareholders
Not taxed as payroll, but may be subject to income tax
Not a deductible business expense
Must come from profits or retained earnings
Reported on forms such as K-1 or directly on a personal return (depending on business structure)
Business structures like LLCs, S Corporations, and partnerships all handle distributions differently. In most cases, you can only take distributions if the business is profitable.
Payroll vs. Distributions: Side-by-Side Comparison
CategoryPayrollDistributionsRecipientEmployees (including owner-employees)Business owners/shareholdersTax TreatmentSubject to payroll taxesTypically not subject to payroll/self-employment tax (S Corps)FrequencyRegular (weekly, biweekly, monthly)Irregular or as declaredBusiness DeductionYesNoReportingW-2, payroll tax formsK-1, Schedule C, or personal returnLegal RequirementsMandatory if performing servicesOptional, but must follow IRS rules
Q&A Section
Q1: Can I pay myself only through distributions to avoid payroll taxes?
A: No. If you provide significant services to your business, especially in an S Corp or C Corp, the IRS mandates that you take a reasonable salary through payroll. Avoiding this can result in penalties for tax avoidance.
Q2: What is considered a “reasonable salary”?
A: The IRS defines it as what you’d pay someone else to do your job, factoring in time spent, experience, and industry standards. There’s no one-size-fits-all rule, but documentation is key.
Q3: I run an LLC. Can I take a salary?
A: If your LLC is taxed as a sole proprietorship or partnership, you take owner’s draws, not salaries. However, if it’s elected to be taxed as an S Corporation, then yes, you must pay yourself a salary via payroll.
Q4: Are distributions taxed?
A: Yes, but differently from wages. Distributions usually avoid payroll/self-employment taxes (especially in S Corps) but are taxed as part of your overall income based on your share of the company’s profits.
Q5: Can I take distributions even if my business isn’t profitable?
A: No. Distributions should only come from profits or retained earnings. Otherwise, you may be withdrawing capital, which has its own tax and operational consequences.
When to Use Payroll vs. Distributions
Use Payroll When:
You’re working in the business and it’s structured as an S Corp or C Corp
You have employees or contractors
You want to pay into Social Security and Medicare for future benefits
Use Distributions When:
You’re taking profit beyond your salary
You own part of a business structured as an LLC, S Corp, or partnership
The business is profitable, and you want to share in its success
Many owners use a combination: payroll for compliance, and distributions for additional income.
Compliance and Risk
The IRS watches closely for misclassification. Taking distributions instead of salary to avoid taxes can result in:
Back taxes owed
Interest and penalties
Audit flags
Best Practices:
Keep clean and accurate records
Use payroll services or accounting software
Work with a CPA or tax professional to determine fair compensation strategies
Conclusion
While both payroll and distributions provide income, they serve very different purposes. Payroll compensates for labor and is subject to employment taxes, whereas distributions reflect ownership profit sharing and follow a separate set of tax rules.
Misunderstanding or misclassifying them can cost your business. Educating yourself and seeking expert guidance is essential.
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