The basic question
An owner of a business that nets, say, $200,000 in 2026 has multiple ways to be taxed:
- Sole proprietor (Schedule C): All net profit is subject to self-employment (SE) tax of 15.3% (12.4% Social Security up to $176,100, plus 2.9% Medicare uncapped, plus 0.9% Additional Medicare Tax above $200,000 single / $250,000 joint).
- Single-member LLC: Default tax treatment is the same as sole proprietor — the LLC is a "disregarded entity" for federal tax purposes. The same 15.3% SE tax applies.
- Multi-member LLC: Default is partnership taxation. Active members generally pay SE tax on their share.
- LLC electing S-Corp (or corporation electing S-Corp): Owner-employee receives a W-2 reasonable salary subject to FICA. Remaining profit flows through K-1 as ordinary income, NOT subject to FICA or SE tax. This is the source of the FICA savings.
The S-Corp savings are real, but they are bounded by the reasonable-salary requirement and offset by administrative costs.
The 2026 numbers
| Tax | Rate | Wage / income base |
|---|---|---|
| Social Security (OASDI) — employer | 6.2% | $176,100 wage base |
| Social Security (OASDI) — employee | 6.2% | $176,100 wage base |
| Medicare (HI) — employer | 1.45% | No wage cap |
| Medicare (HI) — employee | 1.45% | No wage cap |
| Additional Medicare Tax — employee only | 0.9% | Wages above $200K single / $250K joint |
| Self-Employment Tax — Social Security | 12.4% | Up to $176,100 net SE × 92.35% |
| Self-Employment Tax — Medicare | 2.9% | All net SE × 92.35% |
| Self-Employment Tax — Additional Medicare | 0.9% | SE above $200K single / $250K joint |
| FUTA | 0.6% (after credit) | First $7,000 per employee |
| State Unemployment (SUTA) | 0.5% to 6.0% (varies) | State wage base, varies |
The combined OASDI+HI burden on a self-employed person is 15.3% on 92.35% of net earnings up to the wage base, then 2.9% on net earnings above the base, plus 0.9% Additional Medicare for high earners. The S-Corp owner-employee pays the same 15.3%+ on wages but escapes those taxes on the K-1 distributive share.
Worked example 1 — $80,000 net profit
Sole proprietor (Schedule C):
- Net SE earnings × 92.35% = $80,000 × 0.9235 = $73,880
- SE tax: $73,880 × 15.3% = $11,304
- Half of SE tax deductible above-the-line: $5,652 reduction in Schedule 1
S-Corp election with $50,000 reasonable salary:
- Wages: $50,000 (subject to FICA)
- Employer FICA: $50,000 × 7.65% = $3,825
- Employee FICA (withheld from wages): $50,000 × 7.65% = $3,825 (cash flow but is the owner's money in the same hand)
- Total FICA-equivalent burden: $7,650 (employer + employee combined)
- K-1 distributive share: $80,000 - $50,000 - $3,825 (employer FICA, deductible at S-Corp level) = $26,175 — NO FICA
- FUTA: $7,000 × 0.6% = $42
- Total payroll tax burden: ~$7,692
FICA savings: $11,304 - $7,692 = $3,612 gross. But ADD administrative costs: payroll service ~$700/year, separate Form 1120-S preparation ~$1,500-$2,000, state corporate filing fees varying $50-$800. Net savings often near zero or negative at $80K.
Worked example 2 — $150,000 net profit
Sole proprietor:
- $150,000 × 0.9235 = $138,525
- SE tax: $138,525 × 15.3% = $21,194
S-Corp election with $80,000 reasonable salary:
- FICA on $80,000: $80,000 × 15.3% = $12,240 (combined employer+employee)
- K-1 distributive share: $150,000 - $80,000 - $6,120 = $63,880 — NO FICA
- FUTA: ~$42
- Total payroll tax: ~$12,282
FICA savings: $21,194 - $12,282 = $8,912 gross. Less admin costs (~$2,500-$3,000), net savings ~$6,000-$6,500. S-Corp election starts to make sense at this income level if the owner has clear duties that justify $80,000 reasonable salary.
Worked example 3 — $300,000 net profit
Sole proprietor:
- $300,000 × 0.9235 = $277,050
- SS portion: $176,100 × 12.4% = $21,836 (capped at base, applied to net earnings)
- Medicare portion: $277,050 × 2.9% = $8,034
- Additional Medicare: ($277,050 - $200,000) × 0.9% = $693 (single filer)
- Total SE tax: $30,563
S-Corp election with $130,000 reasonable salary:
- SS on $130,000: $130,000 × 12.4% = $16,120
- Medicare on $130,000: $130,000 × 2.9% = $3,770
- K-1 distributive share: $300,000 - $130,000 - employer FICA $9,945 = $160,055 — NO FICA
- Total payroll tax: ~$19,890
FICA savings: $30,563 - $19,890 = $10,673 gross. Less admin (~$3,000), net savings ~$7,500-$8,000. Material at $300K, but the reasonable salary must reflect the owner's role.
Worked example 4 — $500,000 net profit (high reasonable salary required)
Sole proprietor:
- $500,000 × 0.9235 = $461,750
- SS: $176,100 × 12.4% = $21,836
- Medicare: $461,750 × 2.9% = $13,391
- Additional Medicare: ($461,750 - $200,000) × 0.9% = $2,356
- Total SE tax: $37,583
S-Corp election with $200,000 reasonable salary:
- SS on $176,100 (capped): $21,836
- Medicare on $200,000: $5,800
- Additional Medicare on excess: 0 (under $200K wage threshold for additional 0.9% but waged at $200K threshold)
- K-1: $500,000 - $200,000 - employer FICA $13,818 = $286,182 — NO FICA
- Total payroll tax: ~$27,636
FICA savings: $37,583 - $27,636 = $9,947 gross. The savings plateau at higher income levels because the SS wage base caps the SS portion of both options.
Reasonable salary — the IRS factor analysis
The reasonable salary requirement comes from IRC §3121(d)(1) and is enforced through Revenue Ruling 74-44 and case law. The IRS does not provide a safe-harbor percentage. Tax courts apply factor analysis from cases including Watson v. Commissioner (5th Cir. 2012), Glass Blocks Unlimited v. Commissioner (T.C. Memo 2013-180), and Sean McAlary Ltd v. Commissioner (T.C. Summary 2013-62).
The factor analysis (drawn from case law):
- Owner's training and experience. A licensed CPA/JD/MD owner of a service business has higher reasonable salary than a non-credentialed owner doing the same work.
- Duties performed. Hands-on operations, client work, sales, billing — all suggest higher salary. Passive owner role suggests lower.
- Time devoted. Full-time owner-operator vs part-time investor.
- Comparable industry wages. BLS Occupational Employment Statistics, RCReports, Bizstats, salary surveys.
- Use of professional services. If the S-Corp pays large outside contractor fees, owner's role may be less hands-on.
- Dividend / distribution history. Excessive distributions vs minimal salary is a red flag.
- Compensation plans for non-shareholder employees. If non-owner managers earn $150K, owner-manager salary should be reasonable in that range.
- Financial condition of the company. A company that paid distributions but no salary at all draws scrutiny.
In Watson v. Commissioner, an Iowa CPA-shareholder paid himself $24,000 wages and took $203,000 in distributions. The Tax Court reclassified $67,000 of distributions as wages based on industry comparables and the owner's role. The court ordered the FICA, with interest and penalties.
Form 2553 election mechanics
| Item | Detail |
|---|---|
| Form | Form 2553, Election by a Small Business Corporation |
| Filing deadline (general) | 2 months 15 days after the beginning of the tax year for which the election takes effect, OR any time in the preceding year |
| Late election relief | Rev. Proc. 2013-30 — must demonstrate reasonable cause and meet 8 conditions |
| Eligible entities | Domestic corporations, LLCs that have elected to be taxed as a corporation (Form 8832 + 2553 or combined under Rev. Proc. 2013-30) |
| Shareholder limits | 100 or fewer shareholders, all individuals (with some trusts/estates), no nonresident alien shareholders, single class of stock |
| Where to file | IRS service center listed in current Form 2553 instructions, by mail or fax |
An LLC that wants to be taxed as an S-Corp should file Form 2553 and (if the LLC has not already elected corporate treatment) the election under Rev. Proc. 2013-30 streamlines the dual filing. The Form 2553 must be signed by all shareholders and the corporation. Once effective, the election cannot be revoked except by majority shareholder consent and the entity cannot re-elect S-Corp status for 5 years after revocation (with limited exceptions).
Costs that offset the S-Corp savings
- Payroll service: $40-$120/month for Gusto, ADP Run, or QuickBooks Payroll = $480-$1,440/year.
- S-Corp tax return preparation: Form 1120-S preparation by a CPA typically $1,200-$2,500.
- Personal Form 1040 with K-1: Adds $200-$500 to personal return cost.
- Bookkeeping: Required to support reasonable salary analysis. $1,500-$5,000/year if outsourced.
- State corporate filings: Annual report fees vary — California $800/year minimum franchise tax, Delaware $400+ depending on assumed par capital, Texas no annual fee for most LLCs.
- Workers' compensation: Required for owner-employee in some states even if owner is sole employee.
- FUTA on owner wages: $42/year on first $7,000.
- SUTA on owner wages: Varies by state, $40-$420/year typical.
Total annual administrative cost: $2,500-$8,500 depending on state, complexity, and whether the owner self-prepares.
The QBI deduction interaction (IRC §199A)
Both LLCs taxed as sole proprietorships and S-Corps allow the Qualified Business Income (QBI) deduction up to 20% of qualified business income, subject to wage and unadjusted basis (UBIA) limitations for high-income taxpayers and Specified Service Trade or Business (SSTB) limitations.
S-Corp interaction:
- QBI is the K-1 distributive share, NOT the W-2 wages paid to the owner.
- For high-income owners (above $232,100 single / $464,200 joint in 2025-2026 indexed), the QBI deduction is limited by W-2 wages paid by the business. Higher reasonable salary → higher W-2 wages → potentially higher QBI deduction limit.
- For SSTB owners (consultants, lawyers, doctors, accountants, etc.) above the threshold, QBI phase-out is steep.
This means at high incomes the optimal reasonable salary may be HIGHER than the FICA-minimum analysis suggests because higher wages preserve the QBI deduction. CPA modeling is essential at this income level.
FAQ
Can a single-member LLC elect S-Corp?
Yes. A single-member LLC files Form 8832 to elect corporate treatment, then Form 2553 to elect S-Corp status, OR uses Rev. Proc. 2013-30 to file Form 2553 alone with the corporate election deemed made. Once elected, the LLC must file Form 1120-S and the owner must take W-2 wages as a reasonable salary.
What if I take no salary at all?
Taking zero or near-zero salary while taking distributions is a red flag for IRS audit. The IRS can reclassify distributions as wages, assess FICA, interest, and penalties. Tax courts have routinely sided with the IRS in zero-salary cases. The "reasonable salary" requirement is the price of the FICA savings.
How does state tax interact?
Most states recognize federal S-Corp election. A few impose state-level corporate tax or franchise tax (CA $800 minimum, DE franchise tax). Some states (NY, NJ) require separate state S-Corp election. State income tax for the owner is generally on the K-1 plus W-2 amount.
What about LLC + S-Corp + multiple owners?
Multi-member LLCs that elect S-Corp must satisfy 100-shareholder limit, individual-only requirement (no other entities except some trusts/estates), no nonresident aliens, and single class of stock. Each owner-employee receives W-2 wages and a K-1. Distributions must be in proportion to stock ownership (no preferential allocation).