How an S Corporation Can Reduce Self-Employment Taxes

Self-employment taxes can take a sizable bite out of business income, especially as profits grow. An S corporation may help reduce that burden by allowing eligible owners to split earnings between salary and distributions, but the strategy comes with payroll rules, filing requirements and other tradeoffs that can affect whether the tax savings are worthwhile.

If you are an entrepreneur, a financial advisor can work with you to create a financial plan for your needs and goals.

How Self-Employment Taxes Work

Self-employment tax generally applies to net earnings from a trade or business when you work for yourself. It primarily covers Social Security and Medicare taxes, which employees and employers normally split through payroll withholding.

For most self-employed workers, the combined self-employment tax rate is 15.3%. That includes 12.4% for Social Security, up to the applicable annual wage base, and 2.9% for Medicare, which generally applies without a wage cap. Higher-income taxpayers may also owe an additional 0.9% Medicare tax once earned income exceeds certain thresholds.

The tax is generally calculated on 92.35% of net self-employment earnings rather than the full amount. Self-employed taxpayers may also deduct the employer-equivalent portion of self-employment tax when calculating adjusted gross income, although that deduction does not reduce the amount of self-employment tax itself.

For example, a sole proprietor with $100,000 of net business income would generally owe self-employment tax on about $92,350 of that amount, subject to the Social Security wage limit and other applicable rules. This can create a substantial tax burden because the business owner effectively pays both the employee and employer shares.

This is where an S corporation can potentially change the tax picture. Instead of treating all business profit as self-employment income, an S corporation can pay the owner a reasonable salary subject to payroll taxes and distribute additional eligible profits without subjecting those distributions to Social Security and Medicare employment taxes.

How S Corporation Taxes Work

An S corporation generally does not pay federal income tax at the corporate level. Instead, its income, losses, deductions and credits pass through to shareholders, who report their share on their individual tax returns. This pass-through treatment generally allows S corporations to avoid the double taxation that can apply to C corporations.

For business owners, one of the biggest potential tax advantages involves payroll taxes. An owner who works for the S corporation is generally treated as an employee and must receive reasonable compensation as wages. Those wages are subject to Social Security and Medicare taxes, along with applicable income tax withholding.

After paying a reasonable salary, an S corporation may also make distributions to its shareholder-owner. These non-wage distributions generally are not subject to Social Security and Medicare employment taxes, which is where an S corporation can potentially create tax savings compared with operating as a sole proprietorship or certain other self-employed structures.

For example, if an S corporation earns $120,000 and determines that $75,000 is reasonable compensation for its owner’s work, the owner could receive $75,000 as wages and potentially take the remaining profit as a distribution, subject to applicable tax and basis rules. Payroll taxes would generally apply to the salary but not to the qualifying distribution.

Business owners cannot simply set an artificially low salary to maximize distributions. The IRS can reclassify distributions as wages when it determines that a shareholder-employee has not received reasonable compensation. Factors such as the owner’s duties, experience, time devoted to the business and compensation for comparable work may all help determine what qualifies as reasonable pay.

How S-Corp Distributions Are Taxed

A business owner reviews her taxes for an S Corporation.

When we talk about distributions, we are referring to shareholders getting their share of the profits from an S Corporation. These distributions are taxed individually, and they are not subject to self-employment taxes, leading to potentially significant tax savings. However, there’s a catch: shareholders must receive a “reasonable compensation” which basically means you must pay yourself a reasonable salary if you work at the company. Your salary is taxed normally in your tax bracket.

Let’s consider a business owner who earns a substantial income of $100,000. Her reasonable compensation might be $80,000, leaving $20,000 as a distribution that isn’t subject to employment taxes (though it would still be subject to regular income taxes). While this strategy could help lower your overall tax liability, you should note that it does not guarantee any tax savings, as it will depend on your specific finances.

Reasons You May Want to Use an S Corporation

One of the main reasons business owners choose an S corporation is the potential to reduce employment taxes. Unlike sole proprietors, whose net business earnings are generally subject to self-employment tax, S corporation owners can divide compensation between a reasonable salary and eligible distributions. The salary is subject to payroll taxes, while qualifying distributions generally are not.

S corporation status can become especially attractive as a business becomes consistently profitable. If earnings are high enough to leave meaningful profit after paying the owner a reasonable salary, the potential payroll tax savings may outweigh the added costs of running payroll, filing additional tax forms and maintaining corporate records.

An S corporation can also provide a clearer separation between business and personal finances. Owners typically pay themselves through formal payroll and take additional profits as distributions, which can create a more structured approach to compensation and cash flow. Depending on how the business is organized, operating through a corporation or LLC taxed as an S corporation may also provide liability protections under state law.

There may be additional tax-planning opportunities as well. Certain business expenses and employee benefits can receive favorable treatment when structured correctly, and pass-through income may qualify for the qualified business income deduction depending on the taxpayer’s circumstances. Because the benefits vary based on income, salary levels, state taxes and business expenses, owners should compare the potential savings with the administrative costs before making an S corporation election.

Risks of Using an S Corp

Electing S corporation status can reduce employment taxes in some situations, but it also adds rules, costs and administrative responsibilities. Business owners should weigh the potential tax savings against the following risks before deciding whether an S corp is the right structure.

Reasonable salary requirements: Shareholder-employees who perform services generally must receive reasonable compensation before taking non-wage distributions, and the IRS can reclassify distributions as wages if compensation is too low.
More administrative work: S corporations generally require payroll, employment tax filings, corporate tax returns and additional recordkeeping, which can increase accounting and compliance costs.
Eligibility restrictions: S corporations must meet specific requirements, including limits on the number and types of shareholders and generally having only one class of stock.
Potential tax penalties: Failing to properly report wages, withhold payroll taxes or meet filing requirements can result in additional taxes, interest and penalties.
Basis limitations: Shareholders must track their stock and debt basis, which can affect whether distributions are taxable and whether business losses can be deducted.
Not always enough savings: Payroll, tax preparation and other administrative expenses can outweigh the employment tax savings for businesses with relatively modest profits.
State-level differences: States may tax or recognize S corporations differently, so the federal tax benefits do not necessarily translate into the same treatment at the state level.

Bottom Line

An S corporation can help some business owners reduce self-employment taxes by separating compensation into a reasonable salary and eligible distributions. The potential savings can be meaningful, but they need to be weighed against payroll requirements, added administrative costs and IRS compliance rules. For profitable businesses, comparing the tax benefits with the extra complexity can help determine whether an S corporation makes financial sense.

Tips for Tax Planning

A financial advisor who specializes in tax planning can help you protect your finances and avoid any unnecessary taxes while helping you maximize how much wealth you keep. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If your tax situation is less complicated, you may just want to estimate what you might be on the hook to pay so you can plan accordingly. If that’s the case, consider using SmartAsset’s free income tax calculator.