S Corp Self Employment Tax: How to Reduce Your Tax Burden

Key Takeaways

• An S corp allows business owners to save on self-employment taxes by splitting income between salary and distributions.
• LLCs without S corp election must pay self-employment tax on all profits, while S corps only pay on salary.
• Choosing S corp status requires compliance with IRS reasonable compensation rules.
• The tax benefits of S corp status often outweigh costs when business profits are consistently $50,000 or more.
• State taxes, franchise fees, and administrative costs can impact whether S corp election is advantageous.
• Failing to follow S corp guidelines may lead to IRS penalties and reclassification of income.
• Consulting with a tax attorney can help determine the best entity choice for your situation.

Self Employment Tax LLC vs S Corp

With self employment tax LLC vs S corp, both entities offer tax advantages, and you can combine the two. Many business owners choose the LLC structure instead of using an S corp because LLCs offer greater flexibility and require less formalities. With that, combining an S corp with an LLC has its advantages, depending on your business goals.

If a business owner participates in the business, the owner must pay self employment taxes. As of 2013, self employment taxes apply to the first $113,700 of wages, net earnings, and tips. Such earnings are also called earned income. When it comes to an S corp, they must pay self employment taxes on services provided to the S corp. They do not pay taxes on profit distributions.

For LLCs, they are taxed in several ways. Sole-owner LLCs are taxed as a sole proprietorships, while multi-member LLCs are taxed as partnerships. Regardless, both LLCs must pay self employment taxes on the first $13,700 of income received. LLCs do not pay business income taxes. Instead, the owners would note the profits they receive on their individual tax returns.

LLCs can choose to be taxed as an S corp. An S corp itself is not a legal entity, but a tax designation from the IRS. This means that an LLC would fall under an S-corp tax classification instead of a sole proprietorship or partnership form of taxation. S corps have advantages, but they do come with more restrictions. If you are thinking of an S-corp tax classification, take note of the following parameters:

• S corps cannot have over 100 shareholders
• S-corp shareholders must be legal residents or U.S. citizens
• Other entities cannot own an S corp, such as C corps, LLCs, and partnerships
• S corps can only have one stock type (no tiered stock allowed)

To get an S-corp election, you must submit Form 2553 to the IRS, including Form 8832 in certain cases. For self employed people, they can choose an S-corp tax classification to avoid paying higher Medicare and Social Security taxes. Self employed people usually pay high Social Security and Medicare taxes (also called self employment taxes). With that, you should know that the IRS could take a closer look at your S corp since you’ll be paying lower self employment taxes overall.

Whether you’re an employee or self employed, you have to pay self employment taxes. When working for another individual, you only need to pay a part of the taxes, while your employer would pay the remaining tax owed. However, the self employed must pay all taxes. An employer-employee tax combination usually amounts to around 15.3 percent.

How Self Employment Tax Works for Business Owners

Self-employment tax covers Social Security and Medicare contributions typically shared between employer and employee. If you are self-employed, you’re responsible for paying both portions, totaling 15.3% (12.4% for Social Security and 2.9% for Medicare). An additional 0.9% Medicare surtax applies to income above $200,000 for single filers or $250,000 for joint filers.

For sole proprietors, independent contractors, and LLC owners (unless S corp status is elected), this tax applies to the entire net earnings of the business. By contrast, S corporations allow owners to pay self-employment taxes only on the salary portion of their earnings, with distributions exempt from these taxes (though still subject to regular income tax). This makes S corp status a strategic option for reducing self-employment tax liability.

How S Corps Reduce Self-Employment Taxes

One of the primary reasons business owners consider S corp status is its potential to reduce self-employment taxes. In a typical LLC taxed as a sole proprietorship or partnership, all net earnings are subject to self-employment tax (currently 15.3%). However, when an LLC elects S corp taxation:

• Only the salary paid to the owner-employee is subject to self-employment taxes.
• Profit distributions are exempt from Social Security and Medicare taxes, although still subject to income tax.

This allows S corp owners to strategically split their income:

• Example: If you earn $100,000, you might pay yourself a $60,000 salary (taxed with payroll/self-employment taxes) and take $40,000 as a distribution (not subject to those taxes), potentially saving thousands in self-employment taxes.

However, the IRS requires that the salary portion be "reasonable compensation" based on industry standards, experience, and role.

Examples of S Corp Self Employment Tax Savings

Consider the following example to illustrate how S corp election can save on self-employment taxes:

In this scenario, the business owner could save over $6,000 in self-employment taxes by electing S corp status, assuming the salary is considered reasonable by the IRS.

S-corp Benefit

For S-corp distributions, you may label a part of your income in the form of a salary and the other as a distribution. You must pay self employment taxes on the salary end of the income, but you’ll only pay regular taxes on the taxed distribution portion of the income. Overall, you can reduce your self employment tax balance drastically by dividing up your income in the right way.

What Qualifies as S Corp Distributions?

S corp distributions represent the portion of corporate profits paid to shareholders outside of wages. These distributions are not subject to self-employment tax, providing a key benefit of S corp status. However, distributions must be made from retained earnings after reasonable salary payments.

Important considerations for distributions include:

• Must be proportionate to ownership shares.
• Cannot replace a reasonable salary.
• Should be properly documented in company records.

Failure to maintain clear separation between salary and distributions could lead to IRS reclassification and penalties.

Reasonable Compensation Guidelines

A critical aspect of S corp tax compliance is paying the business owner a reasonable salary before taking profit distributions. The IRS scrutinizes S corps that pay unreasonably low salaries in an attempt to avoid employment taxes.

When determining reasonable compensation, consider:

• Job title and responsibilities
• Experience and education
• Industry norms and geographic region
• Time devoted to the business

Failing to pay a fair wage can lead to IRS reclassification of distributions as wages, triggering back taxes, penalties, and interest.

S-corp Risks

The IRS tends to examine S-corp classification more closely due to the potential for abuse. For instance, if you make $300,000 in a single year, but only declare $20,000 as salary, you may get a response from the IRS because you’re trying to reduce a large portion of your self employment tax balance. To remedy this, you must give yourself a reasonable salary that’s not artificially low. What’s considered reasonable is up for debate, but the salary should match a typical salary range within your job position.

IRS Scrutiny and Audit Risk

The IRS keeps a close eye on S corps due to the risk of misclassification of income. Owners who pay themselves minimal salaries and take large distributions raise red flags.

To minimize audit risk:

• Document how salary was determined
• Maintain clear payroll records
• Use benchmarks and industry data when setting compensation

Being proactive with compliance can protect your S corp tax savings from IRS penalties.

S-corp Drawbacks

An S corp may save you on self employment taxes in the short-term, but it could cost you in the long-run. As is the case with other corporations, an S corp comes with ongoing legal and accounting costs. Also, certain states compel you to pay added fees and taxes. For instance, an S corp in California must pay 1.5 percent on income with an annual $800 minimum tax balance. However, such a tax does not apply to sole proprietorships.

Additional Costs and Fees for S Corps

While S corps may provide tax savings, they also come with additional costs that may offset some benefits, especially for smaller businesses. Examples include:

• Payroll Service Fees: Required to handle tax withholdings and filings for owner-employee salaries.
• State Franchise Taxes: Many states, such as California, impose annual franchise taxes or minimum fees on S corps.
• CPA or Accounting Fees: Tax preparation for an S corp is generally more complex than for a sole proprietorship or standard LLC.
• Ongoing Compliance Costs: Including corporate recordkeeping, annual reports, and shareholder meeting documentation.

These costs should be factored into your decision when evaluating whether S corp status is right for your business.

Additional Administrative Responsibilities

While the tax savings can be substantial, S corp status introduces new layers of complexity:

• Payroll Requirements: Must run payroll and file related tax forms (e.g., 941, W-2).
• Corporate Formalities: Must maintain meeting minutes, issue stock, and comply with annual filings.
• Bookkeeping and Tax Filing: Must file IRS Form 1120-S annually and provide K-1s to shareholders.

These obligations may increase accounting costs and administrative overhead. For small businesses with limited revenue, the compliance burden may outweigh the tax benefit.

Is an LLC Right for You?

For many small businesses, LLCs offer more flexibility, especially if your business endeavors pertain to real estate. This is because corporations are subject to double taxation, one tax at the business level another when shareholders note their LLC earnings on their personal tax returns. On the other hand, LLCs do not pay business income taxes, and LLC members only pay taxes based on his or her share in the LLC.

When to Choose S Corp Status

S corp status isn’t ideal for every business. Here are some general guidelines for when it might make sense:

Consider an S corp if:

• Your business consistently earns $50,000 or more in net profit
• You’re actively involved in running the business
• You can justify a reasonable salary and still retain profit for distributions
• You want to reinvest savings from reduced self-employment tax

Stick with an LLC or other structure if:

• Your profits are low or inconsistent
• You’re in the early stages of business development
• You prefer simpler tax filing and fewer formalities

Always consult with a qualified tax professional to model your tax scenarios and determine if electing S corp status will lead to real savings.

Industries and Business Types That Benefit Most from S Corp Election

Electing S corp status can be especially beneficial for:

• Service-Based Businesses: Such as consultants, freelancers, marketers, and software developers who have few capital expenses but steady income.
• Professional Practices: Including lawyers, accountants, designers, and real estate agents.
• Small to Mid-Sized Companies: Where the owner actively works in the business and net profits exceed the $50,000–$75,000 range.

However, businesses with high overhead or inconsistent income may not benefit as significantly, especially if profits are often reinvested rather than distributed.

Frequently Asked Questions

1. Does an S corp pay self-employment tax on all profits?
   No. Only the salary portion paid to owner-employees is subject to self-employment taxes. Profit distributions are not subject to these taxes.
2. How does the IRS determine a reasonable salary for S corp owners?
   The IRS expects salaries to reflect what would be paid for similar work in your industry and location. Documenting salary decisions with market data helps reduce audit risks.
3. Are there penalties for misclassifying S corp distributions?
   Yes. If the IRS determines that distributions were used to avoid employment taxes, they may reclassify distributions as wages and impose back taxes, penalties, and interest.
4. What forms are required for an LLC to elect S corp status?
   You must file IRS Form 2553 to elect S corporation tax status. In some cases, Form 8832 may also be required if the entity is changing its classification.
5. Is an S corp election permanent?
   An S corp election remains in place until it is revoked or terminated. Revocation requires shareholder consent and proper notification to the IRS.

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