S-Corp or Not? The Reasonable-Compensation Question

Somewhere around the second profitable year, nearly every business owner hears it from a friend: "You should be an S-corp. You're overpaying." The friend is half right. The S-election is the most common way to trim self-employment tax: 15.3% on net earnings up to the Social Security wage base, then 2.9% (plus a 0.9% Medicare surtax at higher incomes) on everything after that, all before regular income tax. It's also the tax move I see done wrong most often.

Where the savings come from

Once your LLC elects S-corp status, you wear two hats: owner and employee. You run payroll and pay yourself a salary, and that salary gets hit with Social Security and Medicare taxes like anyone's paycheck. Whatever profit is left comes out as a distribution: no self-employment tax, no payroll tax. The savings all come from that gap between your salary and your total profit.

Put numbers on it. Say a consultant nets $200,000. As a sole proprietor, essentially all of it is exposed to SE tax. As an S-corp paying herself a $90,000 salary, only the $90,000 carries payroll tax. The other $110,000 comes out as a distribution without it. Depending on the details, that's five figures a year.

What "reasonable compensation" actually means

Here's the part the friend usually skips. The IRS knows this math as well as you do, and a suspiciously low salary on a profitable S-corp is one of the more dependable ways to get examined. The standard is what you'd have to pay someone else to do your job: your role, your hours, your experience, what comparable professionals earn. If you are the business and the business made $300,000, a $30,000 salary isn't a strategy. It's an invitation.

And no, there's no safe percentage, whatever a forum told you. Sixty-forty splits, fifty-fifty rules: none of that comes from the IRS. Reasonable compensation is a facts question, and it gets decided on your facts.

The costs the friend never mentions

• Real payroll, with real filings: quarterly returns, withholding deposits, a W-2 for yourself. In practice, that means paying a payroll provider.
• A separate business return, Form 1120-S, every year, with its own preparation cost.
• State friction. California charges S-corps a 1.5% franchise tax on net income ($800 minimum) whether or not the election saved you a dime federally.
• A quieter one: your salary reduces the income that qualifies for the 20% QBI deduction, so part of what you save in payroll tax can leak back out in income tax.

So when is it worth it?

My rough line for service businesses: once net profit is consistently clearing $80,000–$100,000, the election usually starts paying for itself. Below that, payroll and compliance costs eat most of the benefit. Above it, the answer still depends on your state, what a defensible salary looks like for your role, your retirement-plan strategy, and your QBI picture, which is a longer conversation than a blog post.