Running an S Corporation in the U.S. is like tightrope walking: there’s a clear path but staying on it takes focus and discipline.

Between IRS rules, payroll and state requirements, and the day-to-day grind of running your business, accounting for S Corporation can start to feel like a second job—which, to be honest, its kind of is.

But here’s the good news: once you figure how S Corp accounting works, it becomes a powerful tool.

It can save you in taxes and help you monitor your financial health as well.

This guide walks you through the essentials: accounting methods, payroll traps, shareholder distributions, and the not-so-fun-but-essential filing requirements.

S Corp Basics (Quick Recap)

First, let’s clear up a common misconception: an S Corporation isn’t a legal entity, it’s a tax election.

You start with a regular corporation or LLC, and then file Form 2553 with the IRS to elect S Corp status.

This election transforms your legal entity to a tax entity with the IRS and allows your business’s income, losses, deductions, and credits to “pass through” to your personal tax return—avoiding corporate-level taxes.

Sounds simple, right? Well… on paper it does.

But in reality, S Corps come with strict timing and accounting rules and if you want to lock into S Corps savings, you have to be always on top of your accounting game.

Choosing an Accounting Method: Cash vs. Accrual

One of your first big decisions is choosing an accounting method: cash basis or accrual.

Most small S Corps choose cash basis because it’s intuitive—you record income when you receive it, and expenses when you pay them.

Easy, clean, and low maintenance.

But there’s a catch: cash basis can distort your true financial performance.

Say you receive a $10,000 prepayment in December but don’t start the work until January—your income and expenses are recorded in different years.

Your books might show a big profit for one year, and a loss the next, even though the project was break-even.

Why is it bad? Well, because with cash-based accounting you will be paying taxes in the year you receive a prepayment.

Accrual accounting fixes that by matching income and expenses to when they’re earned or incurred—regardless of when the money changes hands.

It offers a more accurate picture of your profitability, but it’s more complex and usually requires accounting software and professional accounting help.

So which accounting method is best for you?

• If your business is small and straightforward, cash basis may be all you need.
• If you carry inventory, work on long-term projects, or want sharper insights, accrual might be worth the effort.

Tax Hack: you can maintain accrual books for internal use while filing taxes on a cash basis and benefit from both worlds.

One important note: the IRS doesn’t care which method you choose on your tax returns—just be consistent.

Changing methods later requires Form 3115, and it’s no DIY task. Talk to a tax pro before switching.

S Corps Retained Earnings

S Corp retained earnings on Schedule L of Form 1120S should reflect your financial records, not tax-adjusted numbers.

They are calculated as beginning retained earnings plus net income (or loss) minus shareholder distributions.

However, accounting setups can cause mismatches between financial statements and the tax return. 

Let say, your accounting software believes that shareholder contribution is part of retained earnings. But for the form 1120S, Retained earnings are calculated using a this formula:

Beginning retained earnings + Net income (or loss) – Distributions (not dividends).

To fix this, CPAs often adjust retained earnings in financials to match Schedule L.  

This is a confusing area in accounting if you are still interested, you can read up on it here.

Reasonable Compensation: The Payroll Puzzle

Here’s where many S Corp owners slip up: reasonable compensation.

If you work in your business (and most S Corp owners do), the IRS requires you to pay yourself a salary—reported on a W-2—before taking any distributions.

That salary must be “reasonable,” meaning what you’d pay someone else to do the same job.

This salary is subject to payroll taxes (Social Security and Medicare), so naturally, many business owners want to keep it low.

But too low raises red flags.

The IRS is very focused on this area because skipping payroll taxes = skipping tax revenue.

A common rule of thumb is the 60/40 split—60% of income as distributions, 40% as salary—but it’s not official guidance and nowhere on the IRS website you will find these strategy.

A better approach? Break down your responsibilities and allocate wages based on the time spent in each role.

Tax Hack:  If your business didn’t make money or you didn’t take money out, you may not need to pay yourself!

How to Run Payroll (Without Losing Your Mind)

You have a few options for running payroll as an S Corp owner:

• Use Payroll Software: Modern payroll services handle the tax filings and W-2s automatically. Some even let you pay yourself once a year (great for managing cash flow) while staying compliant.
• Hire a Bookkeeper or CPA: A pro can help with tax planning and coordination, though many will still outsource the actual processing.
• DIY Payroll: Technically possible. Realistically? Risky. Every state has its own payroll rules, and messing up Form 941 or missing deadlines can cost you way more than the software would.

Tax Hack: Pay Your Income Taxes Through Payroll. Instead of making quarterly estimated payments, you can increase your W-2 withholdings and spread your taxes over the year.

Done right, it helps avoid penalties and surprises come tax time.

Distributions: The Other Half of the Equation

After paying yourself a reasonable salary, you can take distributions—the sweet spot of S Corp tax savings.

Distributions aren’t subject to self-employment tax, making them much more tax-efficient than regular wages.

But you must be careful:

• You can’t take more in distributions than your stock basis.
• Basis = your initial investment + earnings – losses – prior distributions.

If you exceed your basis, the excess distribution is taxed as a capital gain. Ouch.

Say, you started the business with $5,000, earned $50,000, and took $45,000 in prior distributions. Your basis is $10,000. If you try to take a $15,000 distribution this year, $5,000 of it will be taxed as a capital gain.

Tracking basis isn’t optional, it’s crucial. Your CPA should file Form 7203 each year along with your individual tax return or at least track it in their accounting workpapers.

What Not to Do (Seriously)

A few common mistakes can land you in hot water:

• Don’t pay personal expenses from your business account.
• Don’t skip payroll forms. File Form 941 quarterly—even if you’re not paying yourself yet.
• Don’t delay taking distributions just to dodge taxes. You will still be taxed on S corps income. Might as well use the cash!

Your S Corp accounting isn’t done the next year. You’ve got filings to do:

• File Form 1120-S – the corporate tax return (no tax due here, just reporting, but has to be filed on time due to big non filing penalties).
• Distribute Schedule K-1s – issued to each shareholder, reporting income and distributions.
• File Form W-2 and Form 940/941 – for payroll.
• State filings and fees – requirements vary, so check your state’s rules.

Yup, this is the “unsexy” part of S Corp life—but it’s critical for staying in good standing.

Final Thoughts: Use Accounting as a Tool, Not a Chore

S Corps can deliver big tax savings, but they aren’t “set it and forget it.”

To fully benefit, you must stay on top of payroll, distributions, and accounting every month—or at least quarterly.

Consistent accounting is the only way to make sure your tax strategies work when you need them.

If you’re considering an S Corp, make sure you have the time, discipline, or professional support to stay ahead of the deadlines and rules.

Otherwise, the tax savings will quickly disappear.