As a self-employed person, all of your profit is subject to self-employment tax, the 15.3 percent that funds Social Security and Medicare, on top of income tax. But once a business is consistently profitable, one election can meaningfully lower that bill: becoming an S corporation and splitting your pay between a salary and distributions. It is one of the most common tax moves for small business owners, and one of the most misunderstood.
Here is how it works and when it pays off.
How the split works
An S corporation lets you pay yourself in two ways: a salary, which is subject to payroll (Social Security and Medicare) taxes, and distributions of remaining profit, which are not. Because only the salary portion pays the 15.3 percent, shifting some profit from salary to distribution can save a chunk of self-employment tax every year, while the income tax on the total stays the same.
Enter your profit and a reasonable salary above to see the potential payroll-tax savings.
The reasonable salary rule
The catch is that the IRS requires the salary to be reasonable, meaning roughly what you would pay someone else to do your job. You cannot pay yourself a token salary and take everything as distributions; that invites audits and penalties. The savings come from the legitimate gap between a fair market salary and your total profit, not from lowballing the salary.
Set a reasonable salary based on your role and industry, then take the rest as distributions. Aggressively lowballing the salary is a red flag that can cost far more than it saves.
When it makes sense
An S-corp election generally pays off once profit is high enough that the self-employment tax savings exceed the added costs, running payroll, extra accounting, and a separate tax return, which often lands somewhere in the range of tens of thousands in profit and up. Below that, the complexity may not be worth it. Because the rules and the reasonable-salary determination matter, this is a move to make with a good accountant, but for the right business the savings are real and recurring.
Estimate the potential benefit above, then confirm the specifics with a tax professional.
Frequently asked questions
How does an S-corp save on taxes?
It lets owners split pay between a salary (subject to payroll tax) and distributions (which are not), so shifting some profit to distributions cuts self-employment tax. Income tax on the total is unchanged.
What is a reasonable salary for an S-corp?
Roughly what you would pay someone else to do your job, based on your role and industry. The IRS requires it to be reasonable, so you cannot take a token salary and everything else as distributions.
When is an S-corp election worth it?
Generally once profit is high enough that the self-employment tax savings exceed the added costs of payroll, accounting, and a separate return, often in the tens of thousands of profit and up.
Should I set up an S-corp myself?
Because the reasonable-salary rule and payroll requirements matter, it is best done with a good accountant. The savings can be substantial, but the setup and compliance need to be right.
Put your own numbers in.
Every idea in this guide has a calculator behind it. Start with yours.
Open the calculator