Every accountant in America has the same conversation with sole proprietors who started making decent money. "You should elect S-Corp status. You'll save on self-employment tax." Most of the time, the recommendation is right. Some of the time, it isn't. And every once in a while, it's actively bad advice for the business in front of them.
The S-Corp election (filed on Form 2553 with the IRS) changes how a business is taxed. Without it, an LLC owner pays self-employment tax — 15.3% — on every dollar of profit. With it, the owner is required to pay themselves a reasonable salary, and only that salary is subject to payroll tax. Everything else gets distributed and skips the 15.3%.
That math sounds appealing right up until you look at the cost of actually running an S-Corp.
You have to set up payroll. That's another monthly filing, plus quarterly state and federal payroll returns, plus a W-2 at year-end. You have to file a separate tax return for the business — Form 1120S. You have to track your reasonable compensation and be ready to defend it if the IRS asks. And in some states, you'll pay a franchise tax or a minimum annual fee just for the privilege of having an S-Corp.
Add all that up and the breakeven isn't where most accountants quote it.
The S-Corp election starts saving real money around $60,000 to $80,000 in net profit. Below that, the costs eat most of the savings.
The number that actually matters is net profit. For a single-owner business, the election starts saving real money around $60,000 to $80,000 in net profit. Below that, the payroll and filing costs eat most of the tax savings. Above $100,000, the savings get serious — usually $4,000 to $10,000 a year depending on the salary level. Above $250,000, it's almost always the right call.
But the number is net profit, not revenue. A consulting firm with $400K in revenue and $40K in profit doesn't benefit from the election. A subcontractor with $120K in revenue and $90K in profit does.
Reasonable compensation isn't a formula. Once you make the election, the IRS expects you to pay yourself a reasonable salary for the work you do. That number isn't "whatever's left after expenses," and it isn't "as low as possible." It's a benchmarking exercise — what would the business pay someone else to do this job? Set the salary too low and you'll lose an audit. Set it too high and you'll give back the savings the election was supposed to create. The right answer usually sits between 40% and 70% of net profit, depending on the industry and how involved you are day-to-day.
A few situations where the election doesn't help. Multiple owners with different levels of involvement — an S-Corp forces a single class of stock, which limits how profits can be split. A business expecting losses in the first year or two — S-Corp losses pass through, but with restrictions LLC partnerships don't have. A business operating in California, where the franchise tax and minimum annual fee can eat the savings on smaller S-Corps. And any business planning to bring on a non-resident or non-individual investor — S-Corps have ownership restrictions LLCs don't.
The election isn't easily reversible. Once you're an S-Corp, switching back usually means a five-year waiting period under most circumstances. Which is why we don't recommend the election until the numbers actually pencil — and why we revisit the math every year as the business grows.
If your accountant pushed the election when you were earning $45K and now your profit has grown to a place where it makes real sense, that's good news. If they pushed it years ago and the savings still aren't showing up after you factor in payroll service and the separate return, that's a conversation worth having before another tax season passes.