Entity choice and the reasonable salary question

How it works

A sole proprietor pays self employment tax of 15.3 percent on nearly all net profit. An S corporation owner who works in the business is an employee of it and has to be paid reasonable compensation through payroll, with Social Security and Medicare tax on that salary split between the owner and the corporation. Profit above the salary passes through to the owner's return as a distribution with income tax but no payroll tax. Reasonable means what a similar business would pay someone else to do the same job, and the IRS looks at duties, hours, training, and what comparable workers earn. The qualified business income deduction is computed on the pass through profit, not on the owner's wages, and retirement contributions are based on the wages.

What it gives

Payroll tax applies only to the salary, not to the distribution portion of profit.

The corporation can run the owner's health insurance and retirement contribution through payroll.

The separate entity can make bookkeeping cleaner for a business with employees.

What it costs, or where the catch is

Payroll, a separate return, and state fees can cost a few thousand dollars a year, which eats the saving at modest profit.

A salary set too low invites the IRS to reclassify distributions as wages with penalties.

A lower salary shrinks the base for retirement contributions and for Social Security benefits later.

A worked example

Jasper nets $140,000 from his IT consulting. As a sole proprietor his self employment tax is roughly $140,000 times 0.9235 times 0.153, about $19,780. As an S corporation paying himself a $80,000 salary, the combined payroll tax is $80,000 times 0.153, which is $12,240, a difference of about $7,540. His accountant charges $2,500 more a year for the corporation's payroll and return, so the net difference is near $5,000.

Where it goes wrong

The common miss is paying a token salary of a few thousand dollars while taking large distributions, which is the pattern the IRS flags first in an S corporation audit.

Who confirms it for you

For your own numbers, a CPA or enrolled agent. This page explains how the rule works for people in general; it does not know your situation and does not tell you what to do.

The official source

IRS: S corporation compensation and medical insurance issues. Every figure that changes by year comes from the site's rules table, which the watcher checks against the official page on a schedule; where a figure is not yet verified, this page says so instead of printing a number.