If you run a profitable business as a sole proprietor, single-member LLC, or partnership, there’s a good chance you’re paying more in self-employment taxes than you need to. The S-Corp election is one of the most straightforward ways to fix that — but it’s not right for everyone.
What the S-Corp election actually does
When your business is taxed as a sole proprietor, every dollar of profit is subject to self-employment (SE) tax — currently 15.3% on the first $176,100 and 2.9% above that. On $200,000 in profit, that’s roughly $28,000 in SE taxes alone, before income tax.
The S-Corp election splits that profit into two pieces: a W-2 salary (subject to payroll taxes) and distributions (not subject to SE tax). Payroll taxes only apply to the salary. That’s where the savings come from.
Example: On $200,000 in net profit, you pay yourself a $90,000 salary and take $110,000 as a distribution. You pay payroll taxes on $90,000 instead of $200,000 — saving approximately $13,000–$17,000 annually.
The “reasonable compensation” requirement
The IRS requires that S-Corp owner-employees pay themselves a “reasonable compensation” — a salary that reflects what you’d pay someone else to do your job. Setting your salary at $1 to maximize distributions is a red flag. Many advisors suggest targeting 40–60% of net business income as a reasonable starting point.
When it makes sense
The S-Corp election makes the most financial sense when your net profit consistently exceeds about $50,000–$60,000 per year. Below that threshold, the administrative costs — payroll processing, additional tax filings, potential state fees — often eat up most of the savings. At $300,000 in net profit, a well-structured election can save $20,000–$30,000 annually.
What it costs to implement
You’ll need to run payroll for yourself (typically $500–$1,500/year), file an additional business tax return (Form 1120-S, typically $500–$1,500 in CPA fees), and potentially pay state minimum taxes depending on where you operate. In Michigan, there’s no significant additional state tax burden for most S-Corps.
The retirement plan angle
Your S-Corp salary also affects retirement plan contributions. Your 401(k) employee deferral is limited to your W-2 compensation. Setting the salary too low to save on SE taxes can inadvertently cap your retirement contributions — which are often a more powerful tool than the SE tax savings alone. This is why the salary decision needs to be made in the context of your full financial plan.
Bottom line: If your net business profit is consistently above $60,000 and you haven’t analyzed whether an S-Corp election makes sense, you’re likely overpaying in taxes. Use our Tax Savings Estimator to run the numbers for your situation.
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