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If you’re a small business owner scouring the internet for tax advice, you may have come across something like this: “Once your LLC makes $50,000, elect S-Corp status and instantly save 15.3% on payroll taxes!”

The problem is that such advice treats business entity selection as a simple binary switch rather than a multi-variable feedback loop. As a former engineer, I often see things as the latter (for better or worse).

This is a somewhat technical piece aimed at business owners and financial advisors. However, it can also be helpful if you’re considering starting a small business. The information below becomes particularly practical when you own a profitable small business.

I’ll present a framework I personally found useful when deciding to make the S Corp election for my own financial planning practice. While I’ve long been aware of the general rules, what really hit home during a deeper dive is that optimizing in one corner of the tax code can create leaks elsewhere. What the right balance is for me may not be right for you.

The considerations I’ll lay out apply primarily to business owners whose entities are structured as an LLC, partnership, or sole proprietorship. There are also (rare) situations in which C Corporations switch to S Corporations. Business entity selection involves many other considerations, particularly from legal, estate, and exit-planning perspectives.

In this piece, we’ll explore the pros and cons of making the “S Corp election” for your small business from a tax planning perspective only. We’ll cover the basic math and four friction factors you should consider before making this leap. Let’s jump in!

Background and the (Flawed?) Baseline Math

Small businesses exist for many purposes, but a fundamental reason is to make a profit. If successful, the next step is figuring out how much of that profit you can keep. This almost inevitably leads to the question of whether you should elect to be taxed as an S Corporation.

Let’s start with the primary benefit of making the S Corp election: allowing the business owner to control wages paid so that “profits” are not subject to payroll taxes.

There are a few things to unpack with that comment. First, what are payroll taxes? Also known as the FICA tax, it is comprised of two parts:

• 12.4% Social Security – capped at wage base ($184,500 for 2026)
• 2.9% Medicare – all eligible income
• Combined Rate of 15.3%

 

This total rate of 15.3% is shared responsibility between the employer and employee. If you’re self-employed, you pay the full 15.3% rate for yourself and your employees. If your only role is as an employee, you pay half the rate, or 7.65%.

Note: For sole proprietors, the effective self-employment tax rate is slightly lower (~14.1%) due to the employer-half deduction on Form 1040, but the 15.3% nominal rate serves as our baseline.

The “standard” S Corp hack is to shift income from self-employment (subject to 15.3% FICA) to S-Corp distributions (exempt from FICA). Put another way, the tax code is designed so that genuine profits are not subject to payroll taxes.

The baseline savings – Barring some constraints in the IRS code- $100,000 shifted from self-employment profit to an S-Corp distribution saves $15,300 in FICA tax annually.

Sidebar: While we won’t go into the technical details in this piece, there’s also something called a Qualified Business Income Deduction (QBID) that helps reduce your federal tax obligations as you shift profits towards distributions instead of salary.

So, when I phrase everything like this, it will seem like you should just make the S Corp election and take all your business profits as distributions. But there are some hidden costs, or at least what we’ll call friction factors, to consider:

• #1 – IRS Defensibility
• #2 – Eroding Future Social Security Benefits
• #3 – Maximizing Retirement Plan Contributions
• #4 – Other Cash Leaks & Admin Items

Factor #1 – IRS Defensibility – Reasonable Comp

The first catch behind the massive potential tax savings of an S Corp is that you must pay reasonable compensation. This is defined as the amount that would ordinarily be paid for “like” services by “like” organizations in “like” circumstances. Yeah, so there’s a decent amount of gray area here.

There are two primary approaches allowed for determining reasonable compensation.

• Market Approach – This method, also called the “industry comparison,” involves comparing your role—such as CEO or general manager—as an owner to non-owner executives in similar companies within the same industry and location. Typically, this results in a higher wage. Although the IRS is more inclined to accept this approach, it usually offers fewer advantages for tax savings.

 

• Cost Approach – Here, you divide your hours among specific job tasks and assign market wage rates to each task. This typically lowers the overall wage because small business owners often perform some “low-value” administrative tasks. For instance, admin work might be valued at $25/hr., while higher-level executive tasks could be valued at $60/hr. Employing the cost approach reduces the overall weighted average of your salary.

 

Both approaches outlined above can require effort and proper documentation. You might need to spend time researching BLS data and industry benchmarks. Although some companies can assist with these calculations, doing so will incur extra costs.

Complex measures may not be strictly necessary, though. The prominent tax court cases I’ve seen start with situations where the owner-employee is not receiving any wages at all! Clearly that’s going to draw the attention of the IRS.

Tip: If you have a profitable S Corp, pay at least “some” salary. Otherwise, you’re unnecessarily drawing the attention of the IRS.

Alternatively, paying a “small” wage like $20,000 when profit distributions are many multiples of that is likely a high-risk strategy regardless of the industry you’re in. The IRS could argue that an “independent investor” would compensate its principal leader more generously if the business is generating substantial profits.

Here are a few more tips as you think about establishing a reasonable comp:

• Track your hours and duties – If any of these change substantially over time, your compensation in wages may need to change (up or down)
• Count Fringe Benefits – While our goal is often to get to the lowest allowed wage, keep in mind that things like health insurance and health savings account contributions paid by the company are added back to the wages that flow through to your tax return, while generally being exempt from FICA taxes. With health insurance costs where they are today, this can make the S Corp math highly favorable.
• Take Annual COLA adjustments – If you keep a round salary figure like $70,000 and never change it for many years, while your business net income grows substantially, that could be a red flag. Applying a COLA increase based on regional inflation metrics is good practice.
• Be careful using formulas – I say this as a reminder to myself because I love formulas. I admit I have a strong desire to set a reasonable comp based on some percentage of business revenue or profits. While that may work under some conditions, there’s no legal standard behind it. An approach based on market data or multiple variables is more likely to withstand an audit. Furthermore, if you’re in a business with highly fluctuating revenues or profits, you’ll end up with volatile wages. That’s likely to result in drastically underpaying or overpaying FICA taxes.
• View it as an outsider – Imagine a role reversal. Would you personally consider working at a different business earning the wage you’re trying to pay yourself as an owner? If the answer is emphatically “No”, there’s a good chance you’re using too low a wage!

 

All these points are meant to put you in the best possible position in an audit. If during an exam, the IRS adjusts your wages (a.k.a. shareholder compensation) upward, a few things can happen:

• They may assess additional employment tax
• They may reduce your QBI deduction (briefly alluded to earlier, but losing this deduction increases your federal taxes)
• You may owe interest and penalties

 

Put another way, take your reasonable comp decision seriously. Otherwise, the IRS can take multiple bites out of the same “apple”.

Factor #2 – The Social Security Bend Point Opportunity Cost

So now we know you need to pay “reasonable” wages, if only to stay compliant with the IRS. But there’s a second reason: Your salary is an investment, not just an expense. What you pay as wages impacts your future Social Security benefits.

Technical tip: Lowering your W-2 salary to save 15.3% today explicitly lowers your Average Indexed Monthly Earnings (AIME) for Social Security (SS). You have these so-called “bend points” that impact your future benefit payout. But as the chart below shows, not every dollar you pay in wages is treated equally.

The Staircase of Diminishing Returns