Smart Bookkeeping for Smart Sellers
Calculate potential S-Corp tax savings vs sole proprietorship
Your total profit before paying yourself
Salary you would pay yourself as employee (typically 40-60% of income)
Annual costs: filing fees, payroll processing, tax prep (typically $1,500-$3,000)
Your marginal tax bracket percentage (10%, 12%, 22%, 24%, 32%, 35%, or 37%)
An S-Corporation election can provide substantial tax savings for self-employed individuals and small business owners earning above $60,000-$80,000 annually. The key benefit is reducing self-employment tax by paying yourself a reasonable salary and taking the remaining profits as distributions, which are not subject to the 15.3% self-employment tax.
Sole Proprietor: All Income × 15.3% SE Tax
S-Corp: Only Salary × 15.3% Payroll Tax
As a sole proprietor, you pay self-employment tax on your entire net business income. With an S-Corp, you only pay payroll taxes on your reasonable salary. The remaining income is distributed as dividends, which avoid the 15.3% tax. This difference creates significant savings for profitable businesses.
Scenario: Net income $100,000, reasonable salary $60,000, distributions $40,000
Sole Proprietorship:
Self-Employment Tax: $100,000 × 15.3% = $15,300
Federal Income Tax: $100,000 × 24% = $24,000
Total Tax: $39,300
S-Corporation:
Payroll Tax (salary only): $60,000 × 15.3% = $9,180
Federal Income Tax: $100,000 × 24% = $24,000
S-Corp Costs: $2,000
Total Tax + Costs: $35,180
Annual Savings
$4,120
The IRS requires S-Corp owners who work in the business to pay themselves a reasonable salary before taking distributions. This prevents business owners from avoiding payroll taxes entirely. A reasonable salary is the amount you would pay someone else to do your job, considering:
Research market rates for similar positions in your industry and geographic area using salary databases.
Your training, experience, and qualifications should be reflected in your salary amount.
Full-time owners should receive higher salaries than those working part-time in the business.
Most S-Corp owners pay themselves 40-60% of net income as salary, with remaining as distributions.
Income threshold: Generally, S-Corp status becomes beneficial when net business income exceeds $60,000-$80,000 annually. Below this threshold, the administrative costs and complexity may outweigh the tax savings.
Active business involvement: You must work in the business to justify taking a salary. Passive investors or those with minimal involvement are not good candidates for S-Corp election.
Stable income: Businesses with consistent, predictable income benefit most. Highly variable income makes it harder to set a reasonable salary and may complicate payroll processing.
Long-term commitment: The setup costs and ongoing compliance requirements mean S-Corp works best for established businesses planning to continue for several years.
| Feature | Sole Proprietorship | S-Corporation |
|---|---|---|
| Formation | Simple, no filing required | Must form LLC then elect S-Corp |
| Self-Employment Tax | 15.3% on all net income | 15.3% only on salary portion |
| Annual Costs | Minimal ($0-$500) | $1,500-$3,000+ |
| Payroll Requirements | None | Must run payroll for salary |
| Liability Protection | None - personal liability | Limited liability protection |
| Best For | Income under $60,000 | Income over $60,000-$80,000 |
IRS scrutiny: The IRS closely examines S-Corps that pay unreasonably low salaries. If your salary is too low relative to your distributions, the IRS can reclassify distributions as wages and assess back taxes and penalties.
State taxes: Some states do not recognize S-Corp status or impose additional taxes. California, for example, charges a 1.5% franchise tax on S-Corps. Research your state's rules before electing S-Corp status.
Professional help recommended: S-Corp compliance is complex. Most owners work with CPAs or tax professionals to ensure proper setup, reasonable salary determination, and ongoing compliance.