Lower your self-employment tax bill by switching to an S corporation
If you own an unincorporated small business, such as a sole proprietorship, a partnership, or an LLC taxed as one of those, a significant part of your tax burden may come from self‑employment (SE) tax. Converting to an S corporation can, in the right circumstances, reduce how much of your business income is exposed to these employment taxes. Always review your specific situation with a qualified tax professional before changing entities.
Self‑employment tax in 2025
SE tax generally applies to net earnings from a sole proprietorship, from a partner’s share of partnership income (other than certain limited partners), and from LLCs that are taxed as sole proprietorships or partnerships. It functions similarly to the Social Security and Medicare taxes that apply to wages.
For 2025, SE tax is 15.3% on the first 176,100 of net SE income: 12.4% for Social Security plus 2.9% for Medicare. Above 176,100, the Social Security part drops off, but the 2.9% Medicare portion continues with no upper cap. For higher‑income taxpayers, an additional 0.9% Medicare tax can apply to the combined total of wages and SE income once it exceeds 200,000 for single filers and heads of household, 250,000 for married filing jointly, and 125,000 for married filing separately.
How an S corporation can help
An S corporation is a pass‑through entity for federal income tax purposes, but its treatment for employment taxes can differ from that of sole proprietorships, partnerships, and similar LLCs. In an S corporation, owner‑operators are typically treated as shareholder‑employees.
The key distinction is that only wages paid to shareholder‑employees are subject to Social Security and Medicare payroll taxes; the pass‑through business income and most cash distributions to shareholders are not, assuming the arrangement follows the rules. By paying yourself a reasonable salary for the work you perform and taking remaining profits as distributions, you may reduce the portion of total business income that is hit by employment taxes.
Important caveats and risks
This strategy depends heavily on paying “reasonable compensation.” The IRS expects shareholder‑employees who materially work in the business to receive a salary that reflects what an unrelated employer would pay for similar services. If the salary is set unreasonably low and most profits are treated as distributions, the IRS can recharacterize some distributions as wages and assess back payroll taxes, interest, and penalties.
Lower salaries can also reduce your ability to contribute to certain employer‑sponsored retirement plans. For example, for a SEP or many profit‑sharing plans, the deductible employer contribution for an S‑corp shareholder‑employee is tied to that person’s W‑2 wages from the S corp. A very modest salary may therefore limit retirement contributions even when total S‑corp profit is much higher. A 401(k) plan may offer more flexibility, but design details, nondiscrimination testing, and overall compensation still matter.
Administrative and state‑level considerations
Operating as an S corporation involves more compliance than a simple sole proprietorship. The corporation (or LLC taxed as an S corporation) files its own federal return and may have additional state filings, payroll reporting, and corporate formalities such as tracking shareholder basis and documenting key actions. There can also be state‑level nuances: some states tax S‑corp income differently, impose separate entity‑level taxes, or do not follow the federal S‑corp rules in full.
These additional costs and complexities need to be weighed against any expected savings in employment taxes. For some smaller or lower‑margin businesses, the administrative burden and professional fees can offset much of the benefit.
Converting to S‑corporation status
If you currently operate as a sole proprietor or a general partnership and want S‑corp treatment, a common path is to form a corporation under state law (or use an existing eligible entity) and then make an S‑election with the IRS. For an LLC that otherwise qualifies, federal rules generally allow the LLC to elect S‑corporation status directly without forming a separate corporation, though state law and your operating agreement still matter.
For a calendar‑year entity, the election for S‑corp treatment is typically due by the 15th day of the third month of the year (March 15) if you want it effective for that year, although there are limited relief provisions for late elections in some circumstances. Because transferring assets and operations from an existing business into an S‑elected entity can have tax and legal consequences, including possible built‑in gain or state issues, professional guidance is strongly recommended. Contact us at Satty to find out more.
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