The IRS doesn’t take kindly to shortcuts , but it does offer legitimate ways to structure a business for tax efficiency. For solo business owners or small partnerships, switching from sole proprietorship or LLC status to an S-Corp often opens a door to meaningful savings. The process isn’t magic—it’s math. Learn to use that math in your favor.
What Is an S-Corp and How It Works
An S-Corp doesn’t pay income taxes itself. Instead, it passes profits and losses through to shareholders, who report them on their personal tax returns. That setup by itself isn’t a tax break. The benefit kicks in when the business generates enough income to justify paying the owner a wage, and treating the rest as a distribution.
Why does that matter? Because wages are subject to self-employment taxes—Social Security and Medicare, totaling 15.3%. Distributions are not. By splitting income between wages and distributions, an S-Corp can shrink the total tax bill, sometimes significantly.
Reasonable Compensation
The IRS requires shareholders who work for the corporation to receive “reasonable compensation.” That means the business must pay its owner-employees a salary comparable to what others would earn for similar work. There’s no fixed formula, but documentation is critical. Look at industry standards, job duties, business profits, and geographic region. If your role is central to the business’s operations, the salary must reflect that. Undervaluing your work invites audits.
Let’s break that down. Say your business earns $150,000 in net income. If you pay yourself a reasonable salary of $80,000 and take the remaining $70,000 as a distribution, you’ll pay employment taxes on the $80,000 but not on the $70,000. That move alone could save you over $10,000 annually. If that salary isn’t backed up with evidence, the IRS could reclassify the distribution as wages and hit you with back taxes and penalties.
How to Elect S-Corp Status
The decision to elect S-Corp status comes with filing Form 2553. That election changes how the IRS views the entity. Instead of treating it like a disregarded entity or partnership, it becomes a pass-through corporation—still avoiding double taxation, but requiring a separate tax return using Form 1120S. Shareholders receive a Schedule K-1 to report their share of income and deductions.
One catch: S-Corps are capped at 100 shareholders and must be U.S. citizens or residents. They can only issue one class of stock. These rules help keep things simple for tax treatment but limit flexibility in ownership. It’s not a fit for every structure, but for many solo operators and closely held businesses, it aligns perfectly with how they already work.
Administrative Costs and Compliance Requirements
Payroll adds administrative overhead. You’ll need to run payroll, pay payroll taxes, and file quarterly reports. That means using a payroll service or accounting software that handles deductions and filings. It’s not an optional chore; compliance is non-negotiable. However, the savings from reducing self-employment taxes usually cover the added costs.
Also, S-Corps don’t shield all income from employment taxes. If you take all income as distributions, the IRS will likely step in. The balance is key. Salary should be set first, then distributions considered after. Some business owners set their salaries low to maximize distributions, but this tactic often backfires during audits.
Let’s Talk About Your S-Corp Options
If you’re considering an S-Corp election or need to adjust how you’re paying yourself, Robert V. Boeshaar, Attorney at Law , can help. We’ll run the numbers, help you structure compensation, and ensure compliance from day one. Schedule a consultation today to build a smarter tax plan that works.
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