Quick answer: An S-corp saves taxes by splitting owner income into a salary (subject to 15.3% payroll/SE tax) and distributions (not subject to self-employment tax). A sole proprietor earning $200,000 pays SE tax on the full amount — roughly $28,000. An S-corp owner paying themselves a $80,000 salary only pays SE tax on $80,000, potentially saving $10,000–$18,000 per year after accounting for additional S-corp filing costs.
The Salary vs. Distribution Split — How It Works
Self-employment tax is 15.3% on the first $168,600 of net income (2024) and 2.9% above that. As a sole proprietor or LLC taxed as a partnership, every dollar of profit is subject to SE tax. When you elect S-corp status, you become a W-2 employee of your own company. Only your W-2 salary triggers payroll taxes — remaining profit flows through as a distribution, taxed only at ordinary income rates with no additional SE tax. On a $200,000 profit: pay $80,000 salary, take $120,000 in distributions. SE tax savings = approximately $120,000 × 15.3% = $18,360. The S-corp does require additional payroll and tax filing costs ($1,000–$3,000/year), so net savings at $200K profit can be $15,000+.
When an S-Corp Election Makes Sense
The S-corp election typically becomes worthwhile when net business profit consistently exceeds $50,000–$60,000 annually — below that level, additional accounting and payroll costs can eat most of the savings. The election also requires running actual payroll (with quarterly deposits and W-2s), maintaining corporate formalities, and paying a "reasonable compensation" salary to owner-employees. The IRS actively scrutinizes S-corps where owners pay themselves unusually low salaries to maximize untaxed distributions. At $100K net profit, a reasonable salary might be $60,000–$70,000; at $300K, it might be $100,000–$120,000 depending on industry.
Additional S-Corp Benefits Beyond SE Tax Savings
An S-corp can also deduct 100% of health insurance premiums for more-than-2% shareholders (reported as W-2 income but deductible on Form 1040). You can contribute to a SEP-IRA or Solo 401(k) based on W-2 wages, and the business can deduct those contributions. The S-corp structure also provides liability protection similar to a C-corp. However, S-corps have restrictions: no more than 100 shareholders, one class of stock, and no foreign shareholders. Consult a CPA before electing S-corp status to ensure it fits your situation and to set a defensible reasonable compensation figure.
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