WTH is a Distribution?

Welcome to Part 3 of the FIRE small business series.

You can see the Introduction and summary of what we are talking about here.  You should also read the disclaimer:

***Disclaimer ***
This is written for educational purposes.  I am writing to explain my understanding of these principles.  Please, do your own research and talk to a licensed professional before putting this into practice.  The intent of this article is to aid in understanding, point you in the right direction, and to allow you to ask a licensed professional questions that may pertain to your individual situation.  If you see something wrong, please let me know with documentation, so that I can adjust and get all the information as correct as possible.
Last time, we talked about different types of retirement accounts available to small business owners.  We opened up a solo 401k so that we can put a large amount of money into our accounts tax advantaged.  We were able to reduce our tax burden by pushing the expenses against the company along with putting a bunch of money in our solo 401k, both through corporate matches, and personal contributions.
We still have to cut a check to Uncle Sam for the payroll taxes though!  Isn’t there something we can do about that?  Enter the shareholder distribution.

WTF is a shareholder distribution?

Let’s back up a minute.  An S-Corp is like any other company you see on the stock exchange, meaning there are shares of the company that are distributed to investors as proof of ownership.

So, like any company, the management can choose to pay some of the company profit on a per share basis to the stock holders.  That, is what we know and love in the FIRE community as a stock dividend.

These dividends are slightly different than a shareholder distribution, but the idea is the same.  This is a distribution of the profit of the company to stock holders based on share ownership, not payment through wages.

This is what is known as shareholder distribution.

Great… so what?

In our case, we’re management and we own 100% of the shares, but we’re also the only employees.  Isn’t that convenient?

So, why would you want to distribute profits opposed to pay yourself as an employee to max out that lovely 401k we set up last time. You know, the one with the glorious 25% match?

Well, these distributions are not subject to payroll tax!  They are subject to your standard income tax, so don’t get too excited.  But, this does mean that you can skirt the whole 15.3% of the self-employment tax on these distributions.

Another new and interesting part is that pass-through income was a major portion of this new tax law.  Pass-through income is now subject to a new deduction!!  HOORAY!!

Here’s the basics:

The deduction is the LESSER of:

20% of the distribution OR

50% of the W-2 income paid

This is also fresh off the press, so no one is really sure how this is all going to be applied or enforced, so take it with a grain of salt.

You can see the whole complicated mess here, but basically:

If you take a distribution of $60K & wages of $0, you can deduct $0.  (20% * $60k = $12k > $0 / 2 = $0)

If you take a distribution of $30K & wages of $30K, you can deduct $6K.  (20% * $30K = $6K < $30K / 2 = $15K)

Now, we’re not only skipping out on the payroll tax, but we’re also allowed to deduct 20% of the value of the distribution.  Wow, there’s really a definite advantage to these distributions.  There are some limits to this, like if your income level is over $315k these deductions start phasing out.  But, if your income is over $315K, good on you… go hire an accountant!

Let’s take a look…

We have our good ole scenario:

  • $100 in income
  • $40k in deductible expenses

But, now we are going to take the entire thing as a distribution opposed to wages.

Draw vs W-2

Whoa… ok… if we pay the entire thing through distributions, we end up with even more coming into our pocket, because we’re not subject to payroll tax.  But, we don’t take advantage of our 401k (as we have no wages), nor do we take advantage of that new deduction ($0 wages/2 = $0 deduction).  But, we’ve upped our total take home from ~$51K (no draw) to ~$54K (all draw).

Well, what if we adjust this some and push some of the income through wages and some through the distribution?

Turns out, if you pay yourself ~40% as wages, and the rest as a distribution, you end up maxing out your take home pay & max out your solo 401k to the tune of ~$55.8K:

Takehome & Tax Rate vs % Wages Paid

Not bad. Now we’re paying a 4.2% tax rate on $100K in income.  The reason why is you end up paying nothing in income tax on your wages because it all drops into your 401k.  Then you avoid some payroll taxes through the distribution on top of that:

40% Paid as Wages

Let’s compare this to our company from last time.  The same default ($100k income & $40K deductible expenses) but with no 401k & with a 401k but no draw.

SE Take Home + 401k ($0K personal + 0% Match):                          $45,907
SE Take Home + 401K ($18K Personal + 25% Match):                     $51,438
SE Take Home + 401K ($18K Personal + 25% Match) + Draw:      $55,819

So, by opening the 401k and having your company match 25% and optimizing the distribution you end up keeping ~$4,500 more dollars (Almost $10K more than both a SE without the 401k & $15k more than the W-2 sap).  Would you look at that?

Before you get all excited, Hang on!!

Not so fast!!!  The IRS is more clever than you might think.  They are wise to this ruse and have made rules that state you must pay yourself a “reasonable” salary before you can pull distributions from your company.  Reasonable is subject to debate, and if you have further questions about it ask a professional. It would make this post about 15,000 words long, but think market rate for the position.

So, in our case above, the market rate of your “job” better be $18K a year or you run the risk of Uncle Sam sending you a nasty gram.  I got one of those before.  I’d rather avoid another, if at all possible.

Do some research, check out Indeed.com or Salary.com to see what the going rate for your position would be, then pay yourself at the bottom of the range.  At least that way it’s justifiable.

For us…

We actually paid everything out as wages and didn’t take a distribution for a couple reasons:

  1. I don’t have access to a 401k at my employer, so this is my only access to one.
  2. It’s >$45k ($18k * 2 + 25% match of wages) that’s all tax advantaged.  Eliminating payroll tax & income tax on the match and income tax on the contributions.
  3. We needed to make sure we paid a “reasonable wage”.  We don’t feel like messing with the IRS again.
  4. Up until a few weeks ago, that pass-through deduction didn’t exist.

Trust me, this is something we are definitely keeping an eye on, so that we can take advantage of it in the future.  Especially, if I end up at a company that matches 401k contributions, then we can eliminate my needing to be on the payroll.

Alas, if there’s one constant in life, it’s change.  We hired someone (yay!), but now we have to open up a standard big boy 401k (boo!).  The solo 401k isn’t going to cut it, and any matching we do is going to have to be done to everyone.  A 25% 401k match to everyone is great, if you can afford it, but we really can’t at the moment.

Regardless… tune in next time as we walk through all the steps to set up a big boy 401k, as it’s a bit more involved than the solo one we’ve been dealing with so far.


  • David February 21, 2018 at 7:49 am

    Another excellent post! The business series has been been super helpful, thank you!

    • Mr WoW February 21, 2018 at 1:42 pm

      You’re welcome! If there’s anything else more detailed you’re wondering about, just let me know.

  • FIRECracker February 22, 2018 at 2:13 pm

    “Turns out, if you pay yourself ~40% as wages, and the rest as a distribution, you end up maxing out your take home pay & max out your solo 401k to the tune of ~$55.8K”

    Nice! That’s some nice optimization you did there. I didn’t know the IRS requires you to pay yourself a “reasonable wage” though. That’s kind of open to interpretation, because depending on your role that range could vary a lot. But yeah, definitely better to play it safe than to mess with the IRS.
    FIRECracker recently posted…What We Learned Playing Robert Kiyosaki’s Cashflow Board Game

    • Mr WoW February 22, 2018 at 4:23 pm

      I figured you would enjoy this.

      The reasonable wage thing is interesting. And really you get to splitting hairs. I don’t know that it’s worth shaving 10 basis points off your tax burden to piss off the IRS.

      Maybe if the company grows to the point where we have a substantial overage, we’ll dig into this more, but at the moment it’s not a huge deal to pay all wages, especially since most of it drops straight into the 401k anyway.

  • Mrs. Groovy February 22, 2018 at 5:11 pm

    Well, I certainly can’t call you an idiot over this post! I’m the idiot because I have trouble following you.

    I think it’s great you’re looking at all the angles. Some scenarios will test the IRS when new rules come into play– but you don’t want to be part of a test case!
    Mrs. Groovy recently posted…Building Groovy Ranch: Update 8

    • Mr WoW February 22, 2018 at 7:39 pm

      Thanks, I guess!

      It’s not that hard. There’s two ways to pay yourself from a company… Wages and Distributions. Wages have payroll tax & you can put into a 401k. Distribution has NO payroll tax & cannot put into a 401k. The idea is to balance the two ways to make it work in your best interest.

      Just leave it to Uncle Sam to make it so unbelievably complex that you need 5 PhD’s to figure it out!!! BLAH!!!!

  • Accidental FIRE February 22, 2018 at 5:44 pm

    Another informative post. I hate it though that they’re making tax laws with highly subjective and debatable things in them, like “reasonable wage”. That just requires more bureaucrats paid with taxpayer money to interpret all this stuff case by case. We could be far more efficient.
    Accidental FIRE recently posted…The Geography Of Student Loan Debt In America

    • Mr WoW February 22, 2018 at 7:40 pm

      Yeah, lovely huh? I can see why they did it, how can you compare a Doctor to a flower salesman? When they both own a company and both are trying to do this. It just sucks that it’s fully left to the interpretation of a judge.

      This was a hard one to write, it’s so complex and full of nuance. I hope it was somewhat clear.

  • Joe February 23, 2018 at 7:13 am

    I was thinking about converting to S corp, but I’m sticking with sole proprietor for now. It seems like once you make more income, S corp is the way to go.

    In 2016, I made just $30k. That was fine as sole proprietor. In 2017, I made $65k and the tax bill was much higher.
    The tax reform should help a bit this year.

    However, if my income increase more, then I really should change to S corp. Is that sound reasoning? This tax stuff is so complicated.

    • Mr WoW February 23, 2018 at 7:41 am

      I do think there are some distinct advantages you can gain from an S-Corp (LLC taxed as one) vs the Sole Proprietor. I know it’s not as easy to set up, and that’s probably why most people go the simple SP way.

      It does get a lot more complicated, so you might come out even based on effort/accountant fees, etc. But yeah, there are certainly some other things you can do.

      I think it’s certainly worth a consultation with a professional to walk through your specifics, especially if your income through the company is continuing to grow. I think it also depends on the type of business: https://www.legalzoom.com/articles/is-it-time-to-convert-your-sole-proprietorship-to-a-corporation-or-llc

      And yeah, I have no idea why it is so complicated. It’s unbelievably complicated. It keeps entire armies of accountants and lawyers employed. I learned a lot just going through the little bit that we went through so I’m hoping that I can share some of that with everyone.

  • Mr. Groovy February 23, 2018 at 7:14 pm

    Thank you, Mr. WoW. I’ve heard of the dreaded “pass through,” of course, but I really didn’t know what it meant. This helped. I now go to bed a little smarter.
    Mr. Groovy recently posted…Building Groovy Ranch: Update 8

    • Mr WoW February 24, 2018 at 11:27 am

      I don’t know that “dreaded” is a word I’d use for it. It can be quite an advantage if you use it properly.

      I’m hopefully that this will help folks understand and be able to ask the right questions. That’s really the point, isn’t it?


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