S corp vs sole proprietor: the self-employment tax saving

As a sole proprietor, self-employment tax applies to 92.35% of your net profit: the Social Security portion at 12.4% up to the annual wage base, and the Medicare portion at 2.9% with no cap, plus an Additional Medicare Tax of 0.9% above $200,000 (single). Every dollar of profit is subject to it, whether you draw it out or leave it in the business.

What changes with an S corp election

Elect S corporation tax treatment and you become an employee of your own business. You pay yourself a salary, subject to ordinary FICA payroll tax on the full wage amount, and take the remaining profit as a distribution, which is not subject to Social Security or Medicare tax at all. Only the salary portion is taxed for payroll purposes; the distribution is not.

This is the entire mechanism behind the tax saving: shrink the portion of profit that is payroll-taxed, grow the portion that is not. It is also exactly why the IRS scrutinizes the salary figure closely.

Reasonable salary is not a number you get to pick

The salary an S corporation pays its owner-employee must be a reasonable salary for the work actually performed, a facts-and-circumstances test, not a fixed percentage of profit or a number chosen purely to minimize tax. The IRS and courts weigh duties performed, time devoted to the business, training and experience, and what comparable businesses pay for similar roles.

Setting salary artificially low to inflate the untaxed distribution is a well-documented audit target. The IRS can recharacterize distributions as wages after the fact and assess back payroll tax, penalties and interest, potentially wiping out the saving the structure was meant to create and adding a real cost on top of it. This is not a theoretical deterrent, treat it as the binding constraint on the whole comparison, not a footnote.

What this comparison leaves out

This is a payroll-tax comparison only. It does not model differences in the Qualified Business Income deduction between the two structures, both of which can differ from a sole proprietorship in ways that partly offset the payroll-tax saving. It also excludes the real costs of running an S corporation: payroll processing, a separate corporate tax return, and in many states a franchise fee or state-level tax that a sole proprietorship does not pay.

When the saving is largest

The saving grows with the gap between your proposed reasonable salary and your total net profit, since every dollar of profit above the salary escapes Social Security and Medicare tax entirely. It shrinks, and eventually disappears, as reasonable salary approaches the full amount of profit, at which point there is little left to distribute and running an S corporation adds cost without adding tax benefit.

Next steps

Enter your net business profit and a proposed reasonable salary into the Sole Proprietor vs S Corp Calculator to see the payroll tax difference side by side, and read the calculator's warnings on reasonable salary before treating the saving shown as final.