A Guide to Self-Employment Taxes as an S Corp

For many small business owners, self-employment taxes feel like an unavoidable burden. A sole proprietorship and a single-member limited liability company (LLC) pay self-employment tax on every dollar of profit, 15.3% covering Social Security and Medicare taxes. But for businesses that grow beyond a certain point, electing to be taxed as an S corporation can dramatically reduce that liability.

An S corp allows owner-employees to split income between salary and distributions. Salaries are still subject to payroll taxes, but distributions generally are not. This structure can unlock significant savings, but it also requires careful measures to ensure compliance. Done right, it’s not just a tax strategy but a financial upgrade that helps professionalize your business.

This guide will walk you through how the tax savings work, what the IRS requires, when an S corp makes sense, and the ongoing responsibilities of operating as one.

Key Highlights

• Self-employment tax, also referred to as FICA taxes, applies to 100% of the profits of a sole proprietor or an LLC, but not to all S corporation income.

• S corps save money by splitting owner compensation into salary (taxed) and distributions (not subject to self-employment tax).

• The IRS requires owner-employees to pay themselves a “reasonable salary” before taking distributions.

• Electing S corp status only pays off once profits cross certain thresholds after accounting for increased payroll and compliance costs.

• Mistakes—like underpaying yourself or sloppy bookkeeping practices—can trigger IRS audits and penalties.

• Ongoing payroll, tax filings, and bookkeeping are essential to maintain savings.

• Professional CPA and accounting support helps ensure compliance and maximizes tax benefits.

Understanding the S Corp Tax Advantage

Salary vs. Distributions: How the S Corp Split Works

A sole proprietor or single-member LLC business pays self-employment tax on all profits. By contrast, an S corp owner must pay payroll taxes only on the salary portion of their income, while distributions are exempt from this tax.

Example:

• Profit: $80,000

• Sole Proprietor: Pays 15.3% self-employment tax on the full $80,000 ($12,240).

• S Corp: Pays a reasonable salary of $40,000 (taxed at $6,120) and takes $40,000 as distributions (no payroll tax).

Result: The owner has approximately $6,120 in S corp self-employment tax savings compared to the sole proprietor.

This side-by-side comparison highlights the primary advantage of S corp status: the ability to designate a portion of income as distributions.

The Most Critical Rule: Paying Yourself a Reasonable Salary

The IRS requires S corp owners who actively work in the business to take a reasonable salary before distributions. This ensures payroll taxes are still collected on a fair share of income.

Factors the IRS considers include:

• Job duties and responsibilities

• Hours worked

• Comparable industry salaries

• Business profits and cash flow

Failing to pay yourself fairly can result in the reclassification of distributions as wages and other tax consequences. If the IRS audits and finds underpayment, you may owe:

• Back payroll taxes

• Penalties

• Interest

IRS Risks of Underpaying Yourself

While the IRS considers several factors in determining whether you're taking a reasonable salary, no official formula exists. Review these risks of underpaying yourself as you formulate your reasonable salary. 

• Triggering an audit due to unusually low wages

• Reclassification of distributions as taxable wages

• Back taxes and penalties that erase any savings

For peace of mind, many S corp owners turn to CPA support for salary benchmarking and making annual adjustments. 

Is an S Corp Right for Your Business?

Not every business benefits from electing to be an S-Corporation. The math has to work out after factoring in the costs of payroll, bookkeeping, and tax preparation.

Income Thresholds: When an S Corp Starts to Pay Off

This table shows why S corps are more beneficial as profits increase.

Hidden Costs and Complexity That Can Cancel Out Savings

In addition to federal taxes, state-level fees and other costs may entirely cancel out savings or significantly alter your initial calculation. Consider the following as you evaluate the switch to S corporation status. 

• State-level S corp taxes and fees (e.g., California, New York)

• Payroll service costs

• More complex tax preparation

When an S Corp Doesn’t Save You Money

Common situations where electing S corp status may not pay off include: 

• Profits under $40,000 annually

• Inconsistent or fluctuating income

• States with high S corp franchise fees

• Owners who are unwilling to maintain payroll and compliance requirements

How to Operate as an S Corp: Key Requirements

Electing S corp status comes with added compliance obligations that you must address to maintain this status and avoid IRS tax trouble.

Setting Up and Running Payroll

As an owner-employee, you must pay yourself via payroll, even if you run a single-member business.

• Payroll must be consistent and reported on a quarterly basis.

• Fluctuating cash flow can make payroll management difficult.

Filing the Right Business Tax Return

The forms you'll use to file your tax return change when you elect S corp status. 

• S corps file IRS Form 1120-S, not Schedule C (Form 1040).

• Owners receive Schedule K-1 to report their share of income on their personal income tax returns. This is an example of pass-through taxation. An S corp is a pass-through entity business structure, meaning profits and losses are passed to each owner to be handled on their personal tax returns.

Maintaining Clean Books

Accurate bookkeeping is essential to track salaries and distributions, as poorly maintained books can undermine the tax benefit and may lead to IRS scrutiny. Accurate bookkeeping is critical to:

• Track salary vs. distributions

• Avoid IRS scrutiny

• Ensure proper tax reporting

This is where outsourcing to 1-800Accountant’s full-service bookkeeping solution can save time and stress, while ensuring error-free output. 

S Corp Savings at Different Income Levels

The table below illustrates how S corp tax savings change with profit levels:

Get Expert Help to Maximize Savings and Avoid Penalties

Electing S corp status can lead to substantial tax savings, but it requires expertise to execute correctly and consistently. Do-it-yourself calculators rarely capture the whole picture—state fees, salary benchmarks, and audit risks all matter.

That’s why many entrepreneurs trust the professionals at 1-800Accountant, America's leading virtual accounting firm, for guidance on S corporations. Our CPAs, EAs, and tax professionals can:

• File IRS Form 2553, Election by a Small Business Corporation to elect S corp status

• Benchmark reasonable salaries and make proactive annual adjustments

• Set up and maintain payroll and bookkeeping systems

• Handle ongoing tax filings and compliance

With this balance of support, you can focus on growing your new S corporation while 1-800Accountant handles the rest.

Schedule a free 30-minute tax savings consultation today to get started.

Frequently Asked Questions (FAQ)

Can my LLC be taxed as an S Corp?

Yes. A single-member or multi-member LLC can elect S corp taxation by filing IRS Form 2553. This allows the business to maintain its LLC structure while benefiting from S corporation tax treatment.

What if my income is inconsistent? How do I pay a salary?

You must still run payroll regularly. In low-profit months, you may need to delay distributions until cash flow stabilizes. Planning with an accountant helps balance salary obligations with cash management, even when income is inconsistent and unpredictable. 

Can I switch to an S Corp mid-year?

Yes, but deadlines apply. The election generally must be made by March 15 for the current tax year. Late elections may be accepted under specific IRS relief provisions.

What happens if I don’t pay myself a salary?

If audited, the IRS can reclassify all distributions as wages if you fail to pay yourself a reasonable salary. You may owe back payroll taxes, plus penalties and interest, if your salary is too low.

How do I know if my current salary is too low?

Compare your pay against industry benchmarks, your role, and business profits. If your salary is significantly below that of comparable roles, it may be flagged. Avoid an unreasonably low salary by consulting with qualified S corp tax professionals. 

Can I adjust my reasonable salary mid-year?

Yes. Businesses with fluctuating income levels can adjust salaries throughout the year. It’s wise to document the reason for the adjustment in the event of increased scrutiny from the IRS or other government agencies. 

How do bonuses fit into reasonable compensation?

Bonuses are permitted but should align with typical industry practices. For IRS purposes, your bonus would count toward your total salary.

How do state taxes affect S Corp savings?

Some states levy franchise taxes or S corp fees that reduce overall savings. California and New York, for example, have higher compliance costs. Understand potential state costs that could impact your S corp's tax savings prior to making the election. 

What happens if the IRS audits my S Corp?

The IRS may review your salary and distributions during an audit of your S corp. If they determine you underpaid yourself, they can reclassify distributions subject to taxes and issue penalties. Proper documentation and CPA support can help mitigate this risk; however, it's always essential to be prepared. The IRS can audit your business even if you're doing everything right. 

Final Thoughts

Electing S corp status can be a game-changer for small business owners ready to scale. However, the savings only hold up if you follow the rules: 

• Pay a reasonable salary.

• Maintain accurate payroll records.

• Keep clean financial books.

For many entrepreneurs, the administrative lift is worth the tax savings, especially when supported by a trusted team of CPAs, EAs, bookkeepers, and tax professionals.

If you’re wondering whether an S corp makes sense for your situation, schedule a free consultation with 1-800Accountant. We’ll run the numbers, handle compliance, and help you decide with confidence.