Business Tax the entity return and what it costs you.

This is the most common structural question an owner-operated business brings us, and it usually arrives framed as “my friend’s accountant said I’m paying too much self-employment tax.” Sometimes that’s right. Often the math doesn’t clear the overhead. Here is how the calculation actually works.

Where the saving comes from

A single-member LLC with no election is disregarded. Its profit lands on Schedule C, and the owner pays self-employment tax on 92.35% of net earnings. Self-employment tax runs at 15.3% — 12.4% for Social Security up to the annual wage base, and 2.9% for Medicare with no ceiling.

With an S election, the owner becomes an employee. The corporation pays a salary, which carries payroll tax, and the remaining profit passes through on a K-1 as a distribution that is not subject to self-employment tax. The saving is the payroll tax you no longer pay on the distributed portion.

The reasonable-salary requirement

The catch, and the reason this is not free money: an S-corp owner who performs services must take reasonable compensation before taking distributions. The IRS position is long-standing, the case law is unfavorable to owners who pay themselves nothing, and a reclassification turns distributions into wages with penalties and interest attached.

Reasonable is defined by what someone else would be paid for the work you actually do — your role, your hours, your industry, your market. We benchmark it against compensation survey data and document the analysis, so the number in the file has support behind it rather than being whatever left the largest distribution.

The break-even math

Take a business throwing off $150,000 of net profit with an owner whose reasonable salary benchmarks at $90,000.

• As a disregarded LLC: self-employment tax applies to $150,000 × 92.35% = $138,525.
• As an S corporation: payroll tax applies to the $90,000 salary. The remaining $60,000 is distributed.
• Difference in the taxed base: $138,525 − $90,000 = $48,525.
• Payroll tax avoided: $48,525 × 15.3% ≈ $7,400.

Against that, the S election adds real cost: a separate corporate return, payroll processing and quarterly filings, a registered agent in some cases, and higher preparation fees. Budget $2,000 to $3,500 a year. In this example the election nets somewhere around $4,000 to $5,400 — worth doing, and it grows with profit.

What else moves the answer

• Health insurance. A more-than-2% S-corp shareholder’s health premiums must run through payroll and appear on the W-2 to stay deductible. Handled wrong, this quietly erases part of the saving.
• Retirement plan. A solo 401(k) or SEP contribution limit is driven by W-2 wages under an S corp rather than by net earnings. A salary set purely to minimize payroll tax can cap the retirement contribution you actually wanted.
• Losses and basis. S-corp losses are limited by stock and debt basis, tracked on Form 7203. An owner planning to fund losses with loans needs the basis mechanics right before the loss year, not after.
• Multiple owners. The single-class-of-stock rule means distributions must be pro rata. Owners used to flexible partnership allocations often find this constraining.

We run this analysis with your actual numbers before recommending the election, and file Form 2553 with the timing set so the election takes effect for the year you want rather than the year after.