Self-Employment Tax vs. S Corp: A Tax Breakdown
Understand the tax implications of your business structure. This guide compares the default self-employment tax model with the strategic S corporation election.
Business owners can choose different ways to structure their taxes, with two common approaches being the self-employment tax framework and the S corporation. Operating as a sole proprietorship means all business profit is subject to self-employment taxes. Alternatively, forming an S corporation changes how an owner is compensated and can lower their tax burden. Understanding the rules for each structure is important for making an informed decision.
The Self-Employment Tax Framework
Individuals operating as sole proprietors, partners, or single-member LLCs pay self-employment (SE) tax on their net business earnings. An owner must file and pay SE tax if the business has net earnings of $400 or more. This system ensures contributions to Social Security and Medicare, similar to payroll taxes for employees.
The SE tax rate is 15.3%, which combines a 12.4% tax for Social Security and a 2.9% tax for Medicare. For 2025, the Social Security portion only applies to the first $176,100 of income, but the Medicare tax applies to all net earnings. A 0.9% Additional Medicare Tax also applies to earnings over $200,000 for single filers or $250,000 for joint filers.
While employees and employers split this tax (7.65% each), self-employed individuals pay the full 15.3%. To equalize this, the tax code allows a deduction for one-half of the SE tax paid when calculating adjusted gross income (AGI). The tax is calculated on Schedule SE, where 92.35% of net profit is multiplied by the 15.3% rate to determine the amount owed.
The S Corporation Tax Alternative
Electing to be taxed as an S corporation changes the tax landscape for a business owner. The owner becomes an employee of their corporation, which allows for a different method of compensation and taxation.
Under an S corp, the owner receives money as both a salary and a profit distribution. The salary is for services performed and is subject to FICA payroll taxes, which total 15.3%. The corporation pays half (7.65%) as an employer tax, and the owner-employee pays the other half (7.65%) through paycheck withholdings. The 0.9% Additional Medicare Tax also applies to wages exceeding the filing status threshold.
The key tax advantage is that the remaining business profits, paid as distributions, are not subject to FICA or self-employment taxes. These profits are still subject to federal and state income tax on the owner’s personal return.
For example, if a business with $100,000 in profit operates as an S corporation and the owner is paid a reasonable salary of $60,000, only that salary is subject to FICA taxes. The remaining $40,000 taken as a distribution is not.
Establishing Reasonable Compensation
The tax savings of an S corporation depend on a concept the IRS monitors closely: reasonable compensation. The IRS requires that any owner providing services to their S corporation must be paid a reasonable salary before taking profit distributions. This rule prevents owners from avoiding payroll taxes by paying themselves an artificially low salary.
Determining a reasonable salary is a fact-based assessment of what a comparable business would pay for similar services. The IRS evaluates whether compensation is appropriate by looking at several factors.
- The owner’s training and experience
- The owner’s duties and responsibilities
- The time and effort the owner devotes to the business
- Compensation paid to other employees for similar work
- Data on what comparable businesses pay for similar services
Business owners should document how they determined the salary to justify the amount. Failure to pay a reasonable salary can lead the IRS to reclassify distributions as wages, resulting in back taxes, penalties, and interest.
S Corporation Election Requirements
Before a business can use the S corporation tax structure, it must meet specific IRS eligibility requirements. The primary requirement is that the business must be a domestic corporation.
The rules also govern shareholders. An S corporation can have no more than 100 shareholders, who must be individuals, certain trusts, or estates. Partnerships, corporations, and non-resident aliens are not permitted as shareholders. The corporation is also limited to only one class of stock.
To make the election, the business must complete Form 2553, Election by a Small Business Corporation. This requires the corporation’s name, address, Employer Identification Number (EIN), and date and state of incorporation. All shareholders must sign a consent statement on the form, agreeing to the election.
How to File the S Corporation Election
After completing Form 2553, it must be filed with the IRS by mail or fax. The correct mailing address or fax number depends on the state where the corporation’s principal business is located and can be found in the form’s instructions.
Timing is a key factor in the election process. To be effective for the current tax year, Form 2553 must be filed no more than two months and 15 days after the beginning of that tax year. A business can also file the election at any time during the preceding tax year. If the deadline is missed, the election will become effective for the following tax year, though late election relief may be available with reasonable cause.
After filing, the IRS will typically send a notification letter, CP261, within 60 days to confirm the election has been accepted. The corporation should keep this acceptance letter with its permanent records as proof of its S corporation status. If no response is received, the corporation should follow up with the IRS.