Key Takeaways

  • S corporations allow owners to reduce self-employment taxes by splitting income between salary (subject to payroll taxes) and distributions (not subject to self-employment tax).
  • Owners must pay themselves a reasonable salary to comply with IRS rules and avoid audits.
  • The IRS defines reasonable compensation based on the role, industry standards, and comparable wages.
  • S corporation income is taxed as a pass-through, avoiding double taxation seen in C corporations.
  • Improper structuring—such as paying an unreasonably low salary—can result in IRS penalties or reclassification of distributions as wages.
  • Electing S corp status (via Form 2553) can help business owners balance tax savings and compliance if they meet the eligibility requirements.

The S corp self-employment tax refers to the self-employment taxes that the owners of S corporations are required to pay. Some business owners are interested in forming various types of business entities, such as S corporations, due to the possibility of reducing self-employment taxes. Here is everything you need to know about S corporation self-employment tax.

Pass-Through Tax Treatment Of S Corporations

For a corporation, the traditional tax structure consists of two taxation tiers:

  • The corporate level
  • The individual shareholder level

The business is an entity that is standalone and files a tax return. The business pays taxes on all of its income. Any income that has been accumulated by the corporation and distributed to the shareholders as dividends is taxed at the individual level on the tax returns of the shareholders.

However, the truth is that there are many small businesses that aren't considered separate entities. Rather, these businesses are sole proprietorships, and the business owners are taxed for the income of the businesses on their personal tax returns.

Many partnerships are simply a combination of multiple sole proprietorships. Accordingly, it would be unnecessarily complex to apply a two-tier tax structure for corporate entities to a partnership. It would also not be very representative of the reality of the matter, which is that the business simply consists of two people joining forces to create a joint venture.

In order to accommodate these types of businesses, the tax code states that partnerships can be taxed like pass-through entities. A pass-through entity has its income taxed at the individual level, rather than the business level. The income is passed to the partners, and the amount passed to each partner depends on the relative shares. This avoids the two-tier double taxation that typically applies to corporate income.

A major challenge that many businesses run into is that they don't want their business to be structured as partnerships. In some cases, LLCs don't want to be taxed like partnerships. Sometimes, the reason is due to liability exposure that can impact the partners, while other times, there exists a desire to make it simpler to transfer the business, particularly in small pieces for the purpose of success planning.

The tax code permits corporations to elect the S Subchapter. By making the S election, the corporation is choosing to be treated, for the purposes of federal taxes, as an S corporation. When a corporation makes an S election, the business is considered a C corporation for legal purposes but is taxed like a pass-through entity. An S corporation needs to meet all the normal legal requirements to establish and maintain the corporation. However, the S corporation is treated similarly to a partnership when it comes to taxes.

The S election permits businesses to enjoy limited liability, transferability, and the other advantages associated with a corporation. However, the business still enjoys the pass-through treatment, which enables the business to avoid two-tier taxation.

An LLC is able to choose to be taxed like a partnership or like a corporation under the rules referred to as "Check the Box." Choosing to be taxed as a corporation involves making the S election.

The tax code has limitations regarding the types of corporations that are allowed to make S elections. The purpose of these limitations is to prevent abuse potential. The number of shareholders that a corporation can have to qualify for S election must be 100 or fewer. Most trusts are not permitted to own S corporations. Also, an S corporation is only allowed to have one stock class. However, there can be non-voting and voting shares.

Besides these restrictions, the S corporation is an appealing choice for many small business owners who want to enjoy the structure of a corporation along with the tax treatment of a partnership. In the eyes of many small business owners, the S corporation is a good compromise between a C corporation and a partnership.

How S Corp Owners Save on Self-Employment Tax

While S corporations enjoy pass-through taxation similar to partnerships, one of the most notable advantages is how they help reduce self-employment tax. In a typical sole proprietorship or partnership, all net business income is subject to the 15.3% self-employment tax (12.4% Social Security and 2.9% Medicare). S corporation shareholders, however, can separate their income into two categories:

  1. Reasonable Salary: Compensation paid for services rendered, which is subject to payroll taxes (Social Security and Medicare).
  2. Distributions (Dividends): The remaining profits passed through to shareholders are not subject to self-employment tax, significantly lowering the overall tax burden.

For example, if an S corp earns $100,000 and the owner pays themselves a $60,000 reasonable salary, only that $60,000 is subject to payroll taxes. The remaining $40,000 distribution avoids the 15.3% self-employment tax, potentially saving thousands of dollars annually.

However, this tax-saving strategy hinges on compliance. The IRS scrutinizes S corps that pay unreasonably low salaries while taking excessive distributions. Business owners must justify their compensation using market standards, the level of responsibility, and company profitability.

S Corporation Dividends And FICA Self-Employment Taxes

S corporations are taxed like partnerships in that an S corporation is viewed as a pass-through entity. However, the rules for self-employment taxes for S corporations and the rules for self-employment taxes for partnerships are not the same.

Reasonable Compensation and IRS Enforcement

The IRS requires that S corp shareholder-employees receive reasonable compensation for the work they perform. This ensures that Social Security and Medicare taxes are properly paid. Determining reasonable pay depends on:

  • The owner’s duties, skills, and experience.
  • Industry compensation data for similar roles.
  • The time and effort devoted to the business.
  • Business size, complexity, and profitability.

IRS audits often focus on this issue. If the IRS deems that the salary was too low, it can reclassify distributions as wages, leading to back taxes, penalties, and interest.

To stay compliant, many business owners rely on CPA evaluations or industry salary surveys to set their pay. Maintaining clear documentation of salary determinations and periodic reviews is a strong defense against audit challenges.

Filing Requirements and Forms for S Corp Owners

To benefit from S corporation tax treatment, a business must:

  1. Be a domestic corporation or LLC eligible to elect S status.
  2. Have 100 or fewer shareholders, all of whom are U.S. citizens or residents.
  3. Issue only one class of stock.
  4. File Form 2553 with the IRS to make the S election.

Once the election is approved, the business files Form 1120-S annually, and each shareholder receives a Schedule K-1, reporting their share of the corporation’s income, losses, and deductions. Salaries must be reported on Form W-2, and payroll taxes must be paid quarterly.

S corp owners should also consider state-specific requirements, as some states impose their own S corporation taxes or franchise fees even when federal taxes are avoided.

Balancing Salary, Distributions, and Retirement Planning

Although S corporations can lower self-employment tax, owners must balance salary and distributions carefully to ensure compliance and maximize retirement contributions. A lower salary may reduce payroll taxes but also limits contributions to retirement plans like SEP IRAs or 401(k)s, which are based on earned income.

To optimize tax and retirement outcomes:

  • Work with a CPA to determine an appropriate salary-to-distribution ratio.
  • Ensure payroll taxes are timely paid and reported.
  • Reassess compensation annually as business profits fluctuate.

Some S corp owners also supplement savings by contributing to Solo 401(k) or Defined Benefit Plans, which offer higher contribution limits for owner-operators who draw consistent salaries.

Common Mistakes When Reducing Self-Employment Tax

Common pitfalls S corporation owners should avoid include:

  • Underpaying salaries to minimize payroll taxes, which can trigger IRS audits.
  • Failing to pay payroll taxes on the salary portion, resulting in penalties.
  • Ignoring state S corp taxes or franchise fees, which may still apply.
  • Not keeping documentation that supports reasonable compensation.
  • Disregarding quarterly tax deadlines for payroll deposits and estimated taxes.

Careful planning and consistent recordkeeping are crucial. While S corporations can deliver substantial self-employment tax savings, they also carry ongoing compliance obligations that sole proprietors or single-member LLCs may not face.

Frequently Asked Questions

  1. How much can I save on self-employment taxes with an S corp?
    Savings depend on your salary-to-distribution ratio. Generally, S corp owners can save up to 15.3% on the portion of profits taken as distributions rather than wages.
  2. What qualifies as a reasonable salary for an S corp owner?
    A reasonable salary is what you would pay someone else to do your job. The IRS looks at your role, experience, and industry pay standards.
  3. Can an LLC elect S corp status to save on self-employment tax?
    Yes. LLCs can file Form 2553 to be taxed as an S corporation, allowing them to divide income between salary and distributions for potential savings.
  4. Do S corp owners pay self-employment tax on dividends?
    No. Distributions from S corporations are not subject to self-employment tax, but salaries are subject to FICA (Social Security and Medicare) taxes.
  5. What happens if the IRS reclassifies my S corp distributions as wages?
    You may owe back taxes, penalties, and interest. To prevent this, ensure that your salary is reasonable and well-documented based on market benchmarks.

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