Bonus vs. Distribution: Optimizing Owner Compensation in AEC

As we approach year-end, questions about how best to move cash to owners – salary, bonuses, or profit distributions – have been front and center. It’s a smart time to revisit the fundamentals, because the right answer is never one-size-fits-all.

Your decisions should reflect today’s facts, not last year’s assumptions. Laws change. Overhead profiles shift. Ownership dynamics evolve. That’s why regular dialogue with your tax advisor, auditor, HR consultant, and wealth manager is essential – especially in multi-owner pass-through entities where one owner’s cash needs may not match another’s.

Start With Structure: Your Entity Drives Your Options

Before analyzing compensation or bonuses, remember the boundaries set by your business structure:

• S-Corporations must distribute dividends proportionate to ownership. All owners must receive distributions at the same time and in the same percentage.
• Differences in compensation must be tied to roles, responsibilities, and contribution – not ownership percentage.
• Profit distributions (dividends) are not compensation and cannot be structured to favor one owner over another. They’re also not an allowed overhead expense per FAR 31.205-6(a)(6).

This is where many decisions start to narrow.

Three Professional Lenses: HR, Tax, and FAR

To understand the downstream impact of compensation decisions, you must evaluate them across three domains.

1. HR & Compensation Strategy

Kristi Weierbach, Ph.D, SPHR, SHRM-SCP, and our Workforce Solutions team emphasize a disciplined framework:

• Set base salary based on the role, responsibility, and market range – typically targeting the midpoint.
• Use metric-driven bonuses to reward performance and accountability.

This means that in a multi-owner company, owners will (and should) earn different total compensations based on their operational and management contributions. Ownership percentage affects distributions, not pay.

2. Tax Perspective

From a tax compliance standpoint, Jen Nelson, CPA, MBA, reinforces the importance of paying owners a reasonable salary. The IRS consistently challenges artificially low owner wages designed to shift income into lower-taxed pass-through earnings.

A reasonable salary protects the business, minimizes audit risk, and keeps your compensation posture defensible.

3. FAR Overhead & State DOT Implications

From a FAR and state DOT perspective, Tony Machi CPA, MBA, reinforces that total compensation – salary plus performance-based bonuses – must remain reasonable under the National Compensation Matrix (NCM). This is especially important for owners and executives whose compensation is routinely reviewed by state DOT auditors.

When S-Corp owners need additional cash to pay taxes, Tony notes it’s perfectly acceptable to use distributions. These are unallowable costs and stay outside the overhead pool, avoiding any distortion to your indirect rates.

However, when compensation and bonuses are within NCM limits, including them in the overhead pool can offer a strategic advantage: those amounts become recoverable through your indirect rate, and in many cases, may also generate profit or fee. In practice, this means you may recover more than the original cost – something distributions can never achieve.

Whether this strategy makes sense depends entirely on your facts. A startup managing cash flow will make different decisions than a mature firm focused on optimizing long-term competitiveness. Compensation choices directly influence your indirect rates:

• Low-overhead firms may be able to absorb additional allowable compensation without affecting competitiveness.
• High-overhead firms must be more cautious – additional bonuses or ownership compensation may push rates above industry norms or above NCM allowances.

A Common Question: “Should We Pay Owners a Bonus to Cover Their Taxes?”

For S-Corp and other pass-through owners, this question comes up every year – and the answer is almost always no.

If the goal is to give owners cash to pay the taxes on income already earned, a distribution is far more efficient. Paying a bonus instead creates unnecessary tax drag and compliance risk.

Here’s why paying a bonus is the wrong tool for that job:

• Bonuses are taxed at ordinary income rates, not pass-through rates.
• Bonuses trigger employer and employee payroll taxes.
• Bonuses increase retirement plan deferrals and employer contributions.
• To get the owner enough net cash, you must gross up the bonus, making it even more expensive.
• Large year-end bonuses can strain cash flow.
• Higher bonuses may push owners over allowable compensation limits under the NCM, jeopardizing allowability and FAR compliance.

If the income is already on the K-1, the tax liability already exists. A distribution – properly structured and compliant with your entity rules – is the cleanest way to support owners.

Start by Asking the Right Questions

Every decision should begin with clarity around your objectives:

• Am I trying to set a fair, market-based base salary?
• Am I trying to incentivize performance?
• Am I trying to get cash into the hands of owners?
• Is my overhead rate high or low – and what am I trying to achieve through compensation strategy?

Your answer to these questions – not tradition or habit – should drive compensation and distribution decisions.

Accelerate Your Success Through Smart Compensation

Getting cash into the hands of pass-through owners is deceptively complex. HR, Tax, FAR, and state DOT compensation rules all intersect – and the “best” solution depends entirely on your fact pattern.

What worked five years ago may no longer be optimal today. Year-end is the perfect time to evaluate your approach. We are committed to delivering customer delight, ensuring your compensation strategy aligns with tax efficiency, regulatory compliance, competitive overhead rates, and the long-term health of your business. Contact us to start the conversation.