1. Why S-Corp Status Saves Self-Employment Tax

A sole proprietor or single-member LLC pays self-employment tax on all net business income. That is 15.3% on earnings up to the Social Security wage base, which is $184,500 for 2026, and 2.9% for Medicare above that, plus the additional 0.9% Medicare surtax at higher income levels.
An S-corp owner instead pays themselves a W-2 salary subject to payroll tax and takes remaining profit as a distribution. That distribution is not subject to self-employment tax or payroll tax at all. It is subject only to income tax.

2. What "Reasonable Compensation" Means

The IRS requires S-corp owner-employees to pay themselves a salary that reflects what a similar role would earn in the open market for similar work, experience, and time commitment. Paying an artificially low salary to maximize distributions is a well-known audit trigger — the IRS has successfully reclassified distributions as wages (with back payroll tax and penalties) in cases where compensation was clearly understated.

3. Worked Example

A consultant nets $200,000 in business profit for 2026.
As a sole proprietor, the full $200,000 is exposed to self-employment tax. With the Social Security wage base at $184,500, that runs to roughly $28,000.
As an S-corp paying a reasonable salary of $90,000 and taking $110,000 as a distribution, payroll tax applies only to the $90,000 salary, costing roughly $13,800.
That is about $14,200 in savings, before subtracting the cost of running payroll and the added compliance work. For most businesses at this profit level, the net benefit is still clearly positive, but it should be modeled rather than assumed.

4. Sole Prop / LLC vs. S-Corp: A Comparison

5. When It's Not Worth It Yet

Below roughly $80,000 in net profit, the cost of running payroll and the added compliance burden often outweighs the self-employment tax savings. This threshold varies by state and by how the business is structured, which is why it should be modeled for the specific business rather than applied as a blanket rule.

6. Step-by-Step Election Checklist

• Confirm net business profit consistently supports the S-corp break-even threshold
• File Form 2553 to elect S-corp status (timing matters — generally within 2 months and 15 days of the tax year for current-year treatment)
• Set up payroll for the owner-employee
• Document a reasonable salary based on role, industry, and time commitment
• Review compensation annually as profit changes

7. Most Common Mistakes

Setting salary too low to avoid payroll tax. This is the single most common S-corp audit trigger. Electing too early. Below the break-even profit level, S-corp status can cost more than it saves once payroll and compliance costs are factored in. Forgetting payroll entirely. An S-corp owner who takes only distributions with no salary at all is a clear compliance violation, not a gray area.

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8. FAQ

Can I elect S-corp status for an existing LLC? Yes — an LLC can elect to be taxed as an S-corp without changing its legal structure, by filing the appropriate election with the IRS.

Does S-corp status affect the QBI deduction? It can, particularly for SSTB owners near the income phase-out threshold, where W-2 wages paid become part of the calculation — see our QBI deduction article.

How is "reasonable compensation" actually determined? Typically by referencing comparable salary data for the role, industry, and region, and documenting that comparison — this is part of what we help clients establish and defend.

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