Why elect S-Corp status
A sole proprietor or single-member LLC pays self-employment (SE) tax on 92.35% of net business income. The rate is 15.3% up to the Social Security wage base ($184,500 for 2026) and 2.9% above it. An extra 0.9% Medicare tax applies above $200,000 ($250,000 joint). An S-Corp is a pass-through entity for income tax, but the owner's compensation is split: a W-2 salary (subject to FICA payroll tax) and distributions (not subject to payroll tax). The savings is the payroll tax you do not pay on the distribution portion.
For a business with $150K of profit, a reasonable salary of $80K with the rest distributed cuts combined payroll and SE tax by roughly $9,000 a year. That's about $21,200 of SE tax as a sole proprietor versus about $12,200 of FICA on the salary. Payroll costs, state unemployment tax, and California's 1.5% S-Corp tax come out of that. Income tax effects move the number too. The catch is that the IRS requires the salary to be reasonable — market-rate for the work performed — and will reclassify excessive distributions as wages (with back tax, interest, and penalties) if it is not.
The reasonable salary requirement
The IRS does not give a formula for reasonable salary. It looks at the facts: the services you provide, your role, the time you spend, what comparable positions pay in your industry and market, and the relationship between salary and distributions. The case law is clear that you cannot set salary at zero, or at a token amount, and take the rest as distributions. In David E. Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), an accountant who paid himself a $24,000 salary while taking more than $200,000 in distributions had part of the distributions recharacterized as wages.
The defensible approach is to set salary based on comparable market data — what a third party would be paid to do the work you do — and document the analysis. We help establish and document reasonable salary so it holds up under examination.
Salary vs. distributions: the mechanics
- Salary (W-2). Subject to FICA (Social Security + Medicare). You must run actual payroll, file quarterly payroll returns (Form 941), and issue a W-2 at year-end.
- Distributions. Not subject to payroll tax. Taken from after-tax profits. Not a substitute for salary — a supplement to it.
- Health insurance. For a more-than-2% S-Corp shareholder, health insurance premiums the corporation pays are included in W-2 wages in Box 1. They aren't subject to Social Security or Medicare tax when the plan rules are met. The owner can then take the self-employed health insurance deduction on the personal return.
- Retirement contributions. An S-Corp can sponsor a 401(k) and profit-sharing plan. Employer contributions are based on W-2 wages only, not distributions, so a low salary also limits what you can put away. A sole proprietor can have a solo 401(k) too. Run the retirement numbers before you set the salary.
The California difference: 1.5% franchise tax
In most states, the S-Corp election is a clean win on payroll tax. In California, there is a cost to weigh: a California S-Corp pays 1.5% of net income as franchise tax, with an $800 minimum. An LLC taxed as a sole proprietorship or partnership doesn't pay the 1.5%. It pays the $800 annual tax, plus an LLC fee once total California gross receipts reach $250,000 ($900 up to $11,790).
So the California math is: SE/FICA savings minus the 1.5% S-Corp franchise tax. For most profitable businesses, the payroll-tax savings exceed the 1.5%, and S-Corp status still wins — but the crossover point is higher than in a no-tax state, and for lower-income businesses the election may not pencil out. We run the numbers before you file Form 2553.
When to elect and how
An S election is made by filing Form 2553. For a calendar-year business, the election must be filed by the 15th day of the third month of the tax year (March 15) to be effective for that year. If you miss the deadline, you can still elect for the following year, or request late election relief under Rev. Proc. 2013-30 if you had reasonable cause and acted consistently with the intent to be an S-Corp (reasonable shareholder compensation, consistent reporting).
Common timing situations:
- New LLC, profitable from day one. Elect before March 15 of the first year to capture the savings immediately.
- Existing LLC that has grown profitable. Elect now if SE tax has become material.
- Real estate holding entity. Rental income is generally passive and not subject to SE tax, so S-Corp status usually does not help for pure rentals. It matters for active businesses — flipping, property management, brokerage, construction.
What we handle
- Entity selection analysis — LLC, S-Corp, partnership, or C-Corp — with the California tax built into the comparison
- Form 2553 filing and late election relief if needed
- Reasonable salary analysis and documentation
- Payroll setup and quarterly compliance (Form 941, DE 9C, EDD)
- Year-end W-2 issuance and owner health insurance reporting
- Retirement plan design (Solo 401(k), defined benefit) layered on the W-2
If you want to see the rough numbers before you talk to us, try our S-Corp reasonable salary calculator. It estimates the payroll-tax savings at different salary levels. Then we refine it with your actual facts, set up the payroll, and make sure the salary is defensible.