Electing S corporation status is one of the most common tax strategies for profitable small businesses, and one of the most commonly misused.
The savings come from splitting your profit between wages and distributions. The risk comes from pushing that split too far. The IRS calls the line reasonable compensation.
First, what an S corporation is (and isn't)
An S corporation isn't a type of entity. It's a tax election (Form 2553) that a corporation or an LLC can make. Your liability protection comes from the corporation or LLC itself, not from the S election.
Should every business elect S status? No. It depends on your profit level, state rules, payroll costs, your other income, and how the election interacts with the qualified business income deduction. It's a decision that can last for years and is hard to unwind, so it deserves a real analysis.
Where the savings come from: an illustration
John owns a carpet installation business, operating alone with no outside investors. After all expenses, the business earns $100,000 before paying John anything.
As a sole proprietor or single-member LLC (no S election)
Self-employment tax applies to 92.35% of the profit at 15.3%:
$100,000 × 92.35% × 15.3% ≈ $14,130
As an S corporation paying John a $60,000 salary through payroll
Social Security and Medicare (employee and employer share) on the wages:
$60,000 × 15.3% = $9,180
The remaining profit is paid as distributions, which are not subject to payroll tax.
Difference: about $4,950 in payroll taxes
That's before the extra costs of running an S corporation: payroll processing, unemployment insurance, a separate corporate tax return, and state minimum taxes and fees. Those costs are why S status rarely makes sense at lower profit levels.
The obvious next question: why not pay a $20,000 salary and save even more? That's exactly what the IRS is watching for.
What "reasonable compensation" means
S corporation owners who work in the business must be paid wages, through payroll, that are reasonable for the services they provide, before or alongside taking distributions. There's no formula. In practice, reasonable compensation is supported by what it would cost to hire someone to do your job (replacement cost) and what comparable businesses pay for similar services (market rate).
The IRS lists factors courts have considered (IRS Fact Sheet FS-2008-25):
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
What happens when the salary is too low
The IRS can reclassify distributions as wages and assess the employment taxes that should have been paid, plus penalties and interest.
The best-known case is David E. Watson, P.C. v. United States (8th Cir. 2012). Watson was a CPA with years of experience who paid himself a $24,000 salary while taking substantially larger distributions from his firm. The court agreed with the IRS that his reasonable salary was far higher and upheld the extra employment taxes. In Sean McAlary Ltd. v. Commissioner (Tax Court, 2013), a real estate broker who paid himself no salary at all had part of his distributions reclassified as wages.
The lesson from these cases: the IRS looks at what the owner actually took out of the company. When an owner's distributions are large and the salary is small, the salary needs solid support.
How to protect yourself
- Document your number. Keep a written record of how you set your salary: your role, hours, and market data such as the Bureau of Labor Statistics occupational wage data or a third-party compensation study. Revisit it when your role or profits change.
- Run it through payroll. Wages must be paid through payroll with withholding and quarterly filings, not as an occasional transfer.
- Health insurance: if you own more than 2%, premiums the S corporation pays for you are included in your W-2 wages (though not subject to Social Security and Medicare tax).
- Consider third-party reports. Reasonable compensation reports from outside providers can strengthen your position, but no report guarantees the IRS will accept your number.
How the QBI deduction fits in
The 20% qualified business income (QBI) deduction was made permanent by the 2025 tax law, and starting in 2026 its income-based phase-in ranges widen. For S corporation owners:
- your salary is not QBI; only the remaining profit is;
- for higher earners, the deduction can be limited by the W-2 wages the business pays, so a higher salary can sometimes increase the deduction; and
- owners of professional service businesses (law, accounting, health and others) lose the deduction above certain income levels.
That interplay is why the "lowest possible salary" is not always the best answer even before considering audit risk.
New Jersey and New York considerations
- New Jersey now generally treats a federal S corporation as a New Jersey S corporation automatically (shareholders can opt out). New Jersey also imposes a minimum tax on S corporations.
- New York requires its own S election (Form CT-6), separate from the federal one. New York City does not recognize S status at all, so S corporations doing business in the city pay the city's general corporation tax.
- Pass-through entity taxes. New Jersey's BAIT and New York's PTET let an S corporation pay state income tax at the entity level, which can work around the federal cap on deducting state and local taxes. The 2025 law raised that cap to $40,000 for 2025 ($40,400 for 2026), but it phases down for higher incomes, so these elections remain valuable for many owners.
The bottom line
An S election can save real money, but only with a salary you can defend. Set it deliberately, document it, and review it every year.