Net Profit (After Expenses, Before Owner Compensation)

The greatest tax savings occur when business income is divided between a reasonable salary (subject to Social Security and Medicare payroll taxes) and owner distributions (not subject to self‑employment tax).

IRS Publication 334 – Tax Guide for Small Business

Reasonable Compensation Requirement

The IRS requires S‑Corporation owners who actively work in their business to pay themselves a reasonable salary that reflects their role, responsibilities, and industry standards. Underpayment can trigger IRS audits and reclassification of distributions as wages.

IRS Fact Sheet FS‑2008‑25 – Wage Compensation for S Corporation Officers
IRS Publication 535 – Business Expenses

Payroll Costs

Operating as an S‑Corporation requires running payroll, which includes costs for payroll service providers, quarterly payroll tax filings, and additional bookkeeping and compliance requirements.

IRS Publication 15 – Employer’s Tax Guide (Circular E)

Other Tax Considerations

Some states impose additional franchise taxes or minimum fees on S‑Corporations. In addition, eligibility for the 20% Qualified Business Income (QBI) deduction can interact with S‑Corp wages, significantly affecting overall tax savings.

IRS Publication 535 – Business Expenses
IRS QBI Deduction FAQs

Additional Benefits of an S‑Corporation

Retirement Contributions

Contributions to retirement plans such as a Solo 401(k) or SEP IRA can often be made pre‑tax, reducing taxable income. Owners can contribute both as the “employee” and the “employer,” maximizing retirement savings.
IRS Publication 560 – Retirement Plans for Small Business

Health Insurance Premiums

Premiums paid for health insurance (for owners owning more than 2%) may be deductible, reducing taxable income. Family coverage may also be included.
IRS Notice 2008‑1 – S Corporation Health Insurance Guidance

Reduced Self‑Employment Taxes

By shifting part of the profit to distributions, owners can reduce the amount subject to Social Security and Medicare taxes.
IRS Guidance on Self‑Employment Tax

Protection of Personal Assets

Like an LLC, an S‑Corporation provides limited liability protection, keeping personal assets separate from business debts and liabilities.
IRS Publication 542 – Corporations

Recommendations for Distributions (Owner Draws)

One of the main advantages of an S‑Corporation is the ability to take distributions in addition to your salary. Best practices include:

Pay yourself a reasonable salary first to meet IRS requirements.

Avoid excessive distributions that leave the business underfunded.

As a general benchmark, keep distributions no more than 1–2 times your salary unless justified by strong margins.

Maintain reserves equal to 3–6 months of operating expenses.

Document all distributions properly and keep business/personal finances separate.

IRS Instructions for Form 1120‑S

Typical Break‑Even Ranges

Net Profit Under $40,000 – Usually not worthwhile; costs outweigh savings.

$40,000 – $60,000 – Borderline; savings may be reduced by fees.

$60,000 – $80,000 – Often worthwhile; allows reasonable salary and distributions.

$100,000+ – Strongly beneficial; substantial self‑employment tax savings.

Example Calculation

Single Owner with $100,000 Net Profit

Sole Proprietorship/LLC: $100,000 × 15.3% = $15,300 tax

S‑Corporation (Salary $50,000): $50,000 × 15.3% = $7,650 tax; $50,000 distribution = no payroll tax

Estimated Savings: $7,650 per year

Rule of Thumb

If your net profit exceeds $60,000/year (after expenses but before owner pay), it’s usually worth analyzing an S‑Corporation election.

Gross revenue is less important than net profit:

$200k gross – $150k expenses = $50k profit (borderline)

$100k gross – $20k expenses = $80k profit (likely beneficial)

Self‑Employment Tax vs. Payroll Tax: What’s the difference?

Self‑Employment Tax is what sole proprietors, single‑member LLCs, and partnerships pay on their business profits. It covers both the employer and employee portions of Social Security and Medicare taxes — a combined 15.3% on net earnings. This is in addition to income tax.

Payroll Taxes are the same Social Security and Medicare taxes, but they’re split between the employer and employee. As an S‑Corporation owner, you pay yourself a salary, and payroll taxes are only calculated on that portion.

The Tax Savings Trigger: With an S‑Corporation, only the portion of your income classified as salary is subject to payroll taxes. The rest, taken as distributions, is only subject to income tax — not the extra 15.3% self‑employment tax.

IRS Guidance on Self‑Employment Tax

Late Election Relief for S‑Corporations

If an eligible business entity fails to file its S‑Corporation election on time, the IRS may grant Late Election Relief, allowing the election to be treated as timely. Relief is often available when the entity can show reasonable cause for the delay and has acted consistently as an S‑Corporation since formation.

Sole Proprietorships generally cannot backdate an election because they are not separate legal entities. To qualify, a sole proprietor must first form an eligible entity (such as an LLC or corporation) and then make the S‑Corp election going forward.

IRS Instructions for Form 2553 (Election by a Small Business Corporation)