The S-corp election is the most over-recommended tax move in small business. It genuinely saves some Fresno and Clovis business owners several thousand dollars a year. It costs others more than it saves. The difference comes down to arithmetic that takes about twenty minutes to run and that most people never run.
What the election actually changes
If you operate as a sole proprietor or a single-member LLC, your entire net profit is subject to self-employment tax: 15.3% on the first tranche of earnings for Social Security and Medicare, then 2.9% Medicare with no ceiling above it.
Elect S-corp treatment and the business pays you a salary. Payroll taxes apply to the salary. The remaining profit passes through to you as a distribution, and distributions are not subject to self-employment tax.
That is the whole idea. Pay yourself a defensible salary, take the rest as distribution, and the payroll tax on that remainder disappears.
Reasonable compensation is where this gets real
The obvious move is to pay yourself a tiny salary and take everything else as distribution. The IRS is thoroughly aware of this. S corporations must pay shareholder-employees reasonable wages for services rendered before making non-wage distributions, and where they do not, the IRS can reclassify those distributions as wages subject to employment taxes.
The factors the IRS weighs include your training, experience and qualifications, the duties you actually perform, the time and effort you devote to the business, what comparable businesses pay for similar work, any compensation agreements in place, and what you pay non-shareholder employees.
Courts have backed the IRS in looking at where the gross receipts come from. Revenue generated by your personal services should be wages. Revenue generated by employees, capital or equipment has a stronger claim to distribution treatment. A consultant who is the entire business has far less room than a contractor with a crew of twelve.
The California cost nobody mentions
Most articles about S-corp elections are written for a national audience and quietly ignore state tax. In California that omission matters.
California imposes a 1.5% franchise tax on S corporation net income, with an $800 annual minimum that applies whether the business is profitable or not. The minimum is waived only in narrow first-year circumstances.
So a California S corp starts each year $800 in the hole relative to an LLC taxed as a sole proprietorship, before the 1.5% on net income. Add payroll processing, a separate business return, and the additional accounting, and the fixed cost of being an S corp in California is meaningful.
So where is the break-even?
There is no universal number, and anyone who gives you one is guessing. But the shape of the answer is consistent.
- Below roughly $50,000 of net profit, the election rarely pays. Reasonable compensation eats most of the profit, leaving little distribution to shelter, while the $800 minimum, payroll costs and extra return are all still owed.
- Between $50,000 and $100,000, it depends entirely on how much of the profit is defensibly distribution rather than wages. A business with employees and equipment has a stronger case than a solo practitioner.
- Above $100,000 of net profit, the election usually makes sense, and above that the savings scale.
Those bands are a starting point for a conversation, not a rule. Your actual answer depends on your industry, whether you have employees, your health insurance situation, your retirement plan, and what a defensible salary looks like for the work you do.
Things that change the math
Retirement contributions
A W-2 salary creates the compensation base for retirement plan contributions. A very low salary limits what you can put into a 401(k) or profit sharing plan. Sometimes the retirement deduction is worth more than the payroll tax savings you gave up to get it.
The QBI deduction
The qualified business income deduction interacts with wages in ways that can reverse the usual advice, particularly for specified service businesses like law, consulting and health. Lowering your salary to cut payroll tax can shrink your QBI deduction by more than you saved.
Health insurance
Shareholder health insurance has its own treatment for more-than-2% shareholders and needs to run through payroll correctly to be deductible.
The mistake we see most often
Someone makes the election, then never runs payroll. They take money out of the business all year as owner draws, and at tax time there are no W-2 wages at all.
That is the worst of both worlds: the compliance cost and the California franchise tax of an S corp, with none of the protection that reasonable compensation provides. It is also the fact pattern most likely to attract attention.
If you make the election, run the payroll. Every quarter, on time.
Talk it through with a Fresno CPA
We will run the numbers for your business specifically rather than quoting a rule of thumb, and tell you honestly if the election is not worth it. That happens more often than you would think. Learn more about our business tax planning work.
Schedule a meeting or call 559-372-9213.
This post is general information, not advice for your specific situation. Tax figures are current for the year stated and many are indexed annually. Talk to a CPA before acting on any of it.
