The S-Corp election is the most oversold tax strategy on the internet and, for the right business, still one of the best. The mechanics are simple; the judgment call is whether your numbers clear the bar. Here's the honest math.
What the election actually changes
As a sole proprietor or single-member LLC, every dollar of net profit is hit with 15.3% self-employment tax (12.4% Social Security up to the wage base, 2.9% Medicare on everything) on top of income tax. Elect S-Corp status and you split your profit into two streams: a salary you pay yourself through payroll — which bears FICA taxes — and shareholder distributions, which don't. The savings live entirely in that second stream.
The math on $120,000 of profit
Sole proprietor: roughly $17,000 in SE tax (after the deduction adjustments). S-Corp paying a $65,000 salary: about $9,900 in combined FICA, with the remaining $55,000 distributed free of employment tax. Gross savings: roughly $7,000. Now subtract the real costs — payroll service around $600–$1,200 a year, the separate 1120-S corporate return at $800–$1,500, possible state franchise taxes (California charges S-Corps 1.5% of net income, minimum $800; some cities like NYC don't recognize the election at all). Net savings on this example: $4,500–$5,500 a year. Worth it. Run the same math on $50,000 of profit with a defensible $40,000 salary and the savings barely cover the compliance costs.
The reasonable compensation trap
The IRS requires your salary to be reasonable for the work you actually do — what you'd have to pay someone else to do your job. A consultant netting $200,000 who pays herself a $25,000 salary is planting a flag for the exam division, and on audit the IRS reclassifies distributions as wages, with back taxes and penalties. Benchmark against BLS wage data for your role and region, document how you set the number, and revisit it annually. Most practitioners land between 35% and 55% of net profit depending on how much of the income is truly the owner's labor.
When the election makes sense — and when it doesn't
- Generally worth it: consistent net profit above roughly $60,000–$80,000, active owner, U.S.-based ownership.
- Think harder: profit is volatile, you plan to reinvest everything, or you're in a high-franchise-tax state where the state claws back the federal savings.
- Usually skip it: side businesses under ~$50,000, businesses winding down, or owners already maxing the Social Security wage base through a W-2 job — the Social Security portion of SE tax largely disappears anyway, shrinking the benefit.
- Remember the retirement angle: salary is the base for retirement plan contributions, so an aggressively low salary also caps your Solo 401(k) employer contribution.
Deadlines and mechanics
File Form 2553 within 2 months and 15 days of the start of the tax year you want the election to apply — March 15 for a calendar-year business. Missed it? Rev. Proc. 2013-30 provides a late-election relief path if you have reasonable cause and have acted consistently with S-Corp status — relief is granted at the IRS's discretion, so file as soon as you catch it. Once elected, you must run actual payroll (with quarterly 941s and a W-2), keep the corporate formalities, and file the 1120-S by March 15 each year.
The election isn't a loophole; it's a trade — compliance overhead for employment-tax savings. Above the profit threshold, the trade is clearly in your favor. Below it, you're buying paperwork. Get someone to run your actual numbers before you file the form, not after.