Quick reference — self-employment tax
Self-employment tax basics:
- Combined SE tax rate (statutory, unchanged): 15.3% (Social Security 12.4% + Medicare 2.9%)
- Social Security wage-base limit (2024): $168,600 — above this, only the 2.9% Medicare portion applies. The wage base limit is adjusted annually; check the IRS page for the current-year amount.
Source: IRS — Self-Employment Tax (Social Security and Medicare Taxes).
There is a lot of confusion and misinformation on the internet about S-Corporations, so today I’m taking a few minutes to clear up this confusion and discuss the advantages, disadvantages, and eligibility requirements of an S-Corp election.
What Is an S-Corp?
An S-Corporation is a small business corporation. The S-Corp election allows the owner(s)/shareholder(s) to only be taxed at the individual level instead of at both the corporate and individual level. We’ll go over an example of this below.
Advantages of an S-Corp
- The big advantage of the S-Corp status is a tax concept called pass-through taxation. Pass-through taxation means that your company isn’t taxed on the income it generates. Instead, this income can be distributed to the owner(s)/shareholder(s).
- Another important advantage is the limited liability protection for owners and shareholders. There is an extra layer of security for your personal assets in the event your company is dissolved or is being sued.
- Your company can attract investors through the sale of shares of stock, giving you investment opportunities for the continued growth of your business.
- Your business will continue to exist even if the owner leaves, retires, or dies.
Disadvantages of an S-Corp
- There is additional paperwork and fees involved. It is necessary to incorporate the business by filing Articles of Incorporation with your state, obtain a registered agent for your company, and pay the appropriate fees. Many states also impose ongoing fees, such as annual report or franchise tax fees. These fees are typically minimal and in most cases, you will recoup the amount you paid in fees with tax savings.
- Because the S-Corp status allows for distributions to a shareholder, the IRS scrutinizes payments to make sure the characterization conforms to reality.
- If the company tax status is compromised by either non-resident stockholder or stock being placed in the corporate entity name, the IRS will revoke the status, charge back-taxes for 3 years, and impose a further 5-year waiting period to regain the tax status.
- S-corp owners are required to pay themselves a “reasonable salary” as employees and that salary is subject to payroll taxes.
What Is Pass-Through Taxation?
Here is an example of how pass-through taxation works for an S-Corp:
Sarah is the owner of a graphic design business which generates $100,000 in profit. Sarah formed an LLC to operate her graphic design business, and she has elected to have it taxed as an S Corporation. Sarah is an employee of the LLC and receives a $40,000 salary. The remaining $60,000 of the business’s profits are passed through the S corporation and reported as S corporation profit on Sarah’s personal income tax return, not as employee salary. Because this $60,000 profit is not viewed as employee wages, neither Sarah nor her company needs to pay Social Security or Medicare tax on this amount. Sarah and her corporation only pay a total of $6,120 in employment taxes (15.3% x $40,000 = $6,120). Then, Sarah just has to pay income tax on the S-corporation profit of $60,000. Had Sarah not elected S corporation status for her LLC, she would have had to pay self-employment tax and income tax on this entire $100,000 profit. This would have required her to pay an additional $9,180 in Social Security and Medicare tax.
How Much Will I Save as an S-Corp?
| Business Structure | Sole Proprietor | S-Corp |
|---|---|---|
| Yearly net income for the business | $100,000 | $100,000 |
| Your reasonable salary | $40,000 | |
| Self Employment Taxes | ||
| Social Security Tax (12.4%) | $12,400 | $4,960 |
| Medicare Tax (2.9%) | $2,900 | $1,160 |
| Total Tax | $15,300 | $6,120 |
| Estimated Tax Savings | $9,180 | |
When Should Your Business Become an S-Corp?
Every business that files for corporation status is first classified as a C Corp or single-member LLC. Once that’s complete, you have to elect to the subchapter S corp status and meet all requirements for an S-Corp.
Answer the Questions Below to Determine if You Qualify for the S-Corp Election:
| You are eligible to elect S-Corp status if you can answer “yes” to all of these questions. | |
|---|---|
| Is your company currently registered with a state as a domestic corporation (e.g. LLC)? | Your company must be registered as a corporation with your state before you qualify for the S-Corp status. |
| Does your company have less than 100 shareholders (owners)? | Your company must have less than 100 shareholders. |
| Are all of your shareholders U.S. citizens or resident aliens? | All of your shareholders/owners must be U.S. citizens. |
| Do all of your shareholders agree to the S-Corp election? | All of your shareholders must agree and sign off on the S-Corp election. |
| Can you pay the shareholder/employees a reasonable salary for their position? | You must pay the shareholder/employees a reasonable salary for their position. |
| Is your company publicly-held? If so, do you only have one class of stock? | If your company is a publicly held company, you can only have one class of stock. |
What Is a Reasonable Compensation for an S-Corp?
There are several factors to take into account when determining a reasonable compensation for an owner/shareholder.
- The employee’s qualifications.
- The nature, extent, and scope of the employee’s work.
- The size and complexity of the business.
- A comparison of salaries paid with the gross income and net income of the business.
- The prevailing general economic conditions.
- A comparison of salaries with distributions (or dividends) to stockholders.
- The prevailing rates of compensation for comparable positions.
- The salary policy of the taxpayer to all employees.
- The amount of compensation paid to a particular employee in previous years.
This can be a quite the undertaking when operating a small business, which is why I always recommend completing the S-Corporation Reasonable Compensation Report. This report synthesizes a proprietary blend of IRS criteria, court rulings, geographic data and a database of wages to accurately assess reasonable compensation for S-Corp and small business owners.
How Do I Apply for S-Corp Status?
- Choose and reserve a legal name. Many states allow you to reserve a legal name with the Secretary of State.
- Draft and file an Articles of Incorporation.
- If advised by your small business attorney, prepare the corporate bylaws to summarize company rules surrounding operations, officer positions and duties.
Keep corporate minutes of all board and shareholders meetings. - Issue stock certificates to the initial shareholders.
- Apply for an Employer Identification Number (EIN) by preparing and submitting an IRS Form SS-4.
- Depending on what type of corporation you are starting, you may need both state and local permits to operate legally.
File the IRS form 2553 within 75 days of your corporation formation.
S-Corp Election Package
- 30 Minute Consultation
- S-Corp Reasonable Compensation Report
- S-Corp Accountable Plan
- Payroll Setup
- Tax Projection
- Federal Tax ID Number (EIN)
- S-Corp Election Form
S-Corp election timing and Form 2553 deadlines
To be taxed as an S-Corporation for a given year, you must file IRS Form 2553 (Election by a Small Business Corporation) by one of these deadlines:
- For an existing entity: No later than 2 months and 15 days after the start of the tax year you want the election to take effect. For a calendar-year business, that’s March 15.
- For a newly-formed entity: Within 2 months and 15 days of the entity’s formation date.
- Late election relief: Under Revenue Procedure 2013-30, you can file up to 3 years and 75 days late as long as you have “reasonable cause” — typically that you intended to operate as an S-Corp from day one but missed the filing deadline. Write “FILED PURSUANT TO REV. PROC. 2013-30” at the top of Form 2553.
The election applies to the entire tax year — there’s no partial-year option. If you miss the deadline and don’t qualify for late relief, you’ll have to operate as your default entity (LLC, partnership, or C-Corp) for that year and re-file for the next year.
S-Corp payroll requirements
One of the biggest changes when you elect S-Corp status is that you become an owner-employee. The IRS requires that every shareholder-employee who provides services to the business receive reasonable compensation via W-2 payroll.
Reasonable compensation must be paid before any owner distributions. The practical consequence: you can’t just take all the money out as tax-free distributions — the IRS will reclassify “unreasonably low” salary as wages and assess back-taxes plus penalties.
Your S-Corp payroll setup needs:
- A payroll service (Gusto, ADP, or QuickBooks Payroll) that handles federal/state withholding, FICA, FUTA, and SUTA
- Quarterly Form 941 federal employment tax filings
- Annual Form 940 for FUTA (unemployment) taxes
- State withholding registration (varies by state)
- W-2 issued to each shareholder-employee at year-end
- Workers’ compensation insurance in most states (some states exempt sole-shareholder S-Corps)
Payroll setup typically takes 2-4 weeks because of state registrations, so plan ahead — don’t wait until December to start payroll for that tax year.
S-Corp and the QBI (Section 199A) deduction
The Qualified Business Income (QBI) deduction lets pass-through business owners — including S-Corp shareholders — deduct up to 20% of their qualified business income from their personal taxes. This is a separate benefit on top of the FICA savings.
For S-Corp owners, QBI is calculated on the K-1 income only — not on your W-2 wages. This creates an optimization problem: paying yourself a higher salary reduces QBI-eligible income (and thus your QBI deduction), but paying yourself too low risks IRS reclassification. The sweet spot varies by income level and industry.
For 2026, the QBI deduction starts phasing out at:
- $249,150 taxable income for single filers
- $498,300 taxable income for married filing jointly
Above those thresholds, “Specified Service Trade or Business” (SSTB) owners — including consultants, accountants, lawyers, doctors, and financial advisors — get a reduced or zero QBI deduction. Non-SSTB businesses can still qualify based on a wage and asset test.
When you should NOT elect S-Corp status
S-Corp election makes sense for most profitable small businesses earning $50,000+ in net profit annually — but not for every situation. Skip the S-Corp election if:
- Your business profit is under $50,000/year. The savings on self-employment tax may not exceed the payroll-administration costs.
- You have foreign shareholders. S-Corps can’t have non-resident-alien shareholders. The election terminates automatically if a non-citizen non-resident becomes an owner.
- You want to raise venture capital. Most VCs require C-Corp status with multiple stock classes; S-Corps only allow one class of stock.
- You operate in California, New York, New Jersey, or Tennessee. These states impose an S-Corp-specific tax (1.5% in CA on income, plus the $800 minimum franchise tax) that can offset federal FICA savings.
- You plan to reinvest all profit back into the business. S-Corp distributions don’t help you if you’re not taking money out.
- You’re a real estate investor. S-Corps complicate basis tracking and prevent 1031 exchanges. LLC taxed as a partnership is usually better.
- You’re a sole proprietor with very seasonal income. S-Corp payroll requirements are awkward when months can pass between paychecks.
Talk to a CPA before electing — the FICA savings calculator gives you the theoretical max, but the practical answer depends on your state, industry, and growth plans.
Common S-Corp mistakes that trigger audits
S-Corp returns get extra IRS scrutiny because the FICA-savings strategy is so well-known. The IRS specifically watches for:
- Unreasonably low W-2 wages. If your salary is $0 or $10K while distributions are $200K, expect an audit. Industry-comparable wage data is required documentation.
- Mixing personal and business expenses. S-Corp owners often run personal purchases through the business card; the IRS treats these as constructive dividends (taxed twice) and adds penalties.
- Failing to issue W-2s to owner-employees. Receiving only K-1 income but actively working in the business is a red flag.
- Late or missing Form 941 filings. Quarterly federal employment tax returns can’t be skipped, even if you didn’t run payroll that quarter.
- Distributions in excess of basis. Distributions above your stock basis are taxed as capital gains — many owners miss this and underpay.
- Loans to/from the shareholder that aren’t documented. Without a real promissory note + interest, the IRS reclassifies them as wages or distributions.
- Health insurance premiums not on the W-2. S-Corp owner-employee health premiums must be added to Box 1 of the W-2 (then deducted as self-employed health insurance on the 1040). Missing this step disallows the deduction.
Owner-employee fringe benefits and retirement plans
S-Corp shareholder-employees owning more than 2% of the company face special rules on fringe benefits. The most important:
- Health insurance: Premiums paid by the S-Corp must be added to your W-2 Box 1 wages (not Boxes 3 or 5 — they’re not subject to FICA). You then deduct the premiums on Form 1040 as self-employed health insurance.
- HSA contributions: Same treatment as health insurance — must be on W-2 Box 1, then deducted on Form 1040.
- Solo 401(k): S-Corp owners contribute as both employee and employer. Employee contributions are limited to $23,500 in 2026 ($31,000 if age 50+). Employer contributions are 25% of W-2 wages (not K-1 income), capped at a combined $70,000 ($77,500 with catch-up).
- SEP-IRA: S-Corp can contribute 25% of W-2 wages (not K-1), with the same $70,000 cap. Simpler than solo 401(k) but lower contribution potential.
- Cell phone, vehicle use, education: Subject to “accountable plan” reimbursement rules — the S-Corp must reimburse you for actual documented business use, not just pay you a flat allowance.
Multi-shareholder S-Corp rules
S-Corps can have up to 100 shareholders, and only certain entities qualify:
- U.S. individual citizens and resident aliens (NOT non-resident aliens)
- Certain trusts (Qualified Subchapter S Trusts, Electing Small Business Trusts, grantor trusts)
- Estates
- Tax-exempt 501(c)(3) organizations
- Other S-Corporations (with the QSub election)
Partnerships, corporations, multi-member LLCs, and non-resident aliens are not allowed as shareholders. Adding an ineligible owner — even briefly — terminates the S-Corp election automatically.
All shareholders must receive distributions in proportion to their ownership percentage. You can’t pay out unequal distributions without risking the election. If a 50/50 owner needs more cash, the path is to increase that person’s W-2 salary or take an equal distribution to both and have one re-loan it back.
State-by-state S-Corp considerations
Federal S-Corp election doesn’t automatically apply at the state level. Each state has its own rules:
- States that follow the federal S-Corp election automatically: Most states (CA, IL, IN, MI, MO, OH, PA, TX, etc.)
- States requiring a separate state-level S-Corp election: NY, NJ, AR, MA, WI, MS
- States that don’t recognize S-Corp status at all: Louisiana (treats S-Corps as C-Corps for state tax), Tennessee (excise tax applies regardless), New Hampshire (Business Profits Tax)
- States with S-Corp surtaxes: California (1.5% of net income + $800 minimum), New York City (8.85% on income), Illinois (1.5% replacement tax)
For multi-state businesses, the S-Corp election impacts state tax liability differently in each state where you have nexus. Run state-specific projections before electing.
How to revoke an S-Corp election
If S-Corp status no longer makes sense, you can revoke the election by filing a written statement with the IRS Service Center where you file Form 1120-S. The statement must include:
- The corporate name, EIN, and address
- A clear statement that the corporation is revoking its S election under IRC §1362(d)(1)
- The effective date of the revocation
- The number of shares of stock outstanding
- Consent statements from shareholders owning more than 50% of the stock
To take effect for the current tax year, file by the 15th day of the 3rd month of the tax year (March 15 for calendar-year filers). After revoking, you generally cannot re-elect S-Corp status for 5 years without IRS consent.
