Overview
Self‑employment tax in the United States is the combination of Social Security and Medicare taxes that someone who works for themselves pays on net earnings. Technically, it is made up of a 12.4% Social Security portion (up to the annual wage base) and a 2.9% Medicare portion, for a total of 15.3% on net earnings, with an additional 0.9% Medicare surtax that applies at higher income levels (see IRS guidance). The way your business is organized affects which portions of your business income are treated as wages (subject to payroll taxes) versus distributions or pass‑through income (which may avoid the self‑employment tax). For authoritative rules, see the IRS Self‑Employment Tax overview (IRS.gov).
How entity choice changes tax treatment
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Sole proprietorship: Business profit is reported on Schedule C of the owner’s Form 1040 and is generally subject to self‑employment tax on net earnings. There’s no separation between owner and business for payroll taxes.
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Partnership: Partners report their distributive shares on Schedule K‑1; general partners typically owe self‑employment tax on their guaranteed payments and distributive share of active business earnings, although special allocations and limited partner status can change treatment.
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LLC (default tax classification): An LLC taxed as a sole proprietorship (single member) or partnership (multi‑member) follows the same pass‑through rules—its active profits are generally subject to self‑employment tax unless the members are passive owners. An LLC can elect corporate tax status to change this treatment.
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S‑Corporation (S‑Corp): An S‑Corp is a pass‑through entity for income tax, but owner‑employees must be paid a reasonable salary for services performed. Salary is subject to payroll taxes (employer and employee shares), while distributions of remaining profits are generally not subject to self‑employment tax. This creates an opportunity to reduce overall payroll tax exposure, but it also requires payroll setup and careful compliance with IRS guidance (Form 2553 is used to elect S‑Corp status).
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C‑Corporation: A C‑Corp pays corporate tax on profits and pays wages to owner‑employees subject to payroll taxes. Dividends paid to shareholders are not subject to payroll taxes but are taxed at dividend rates (and create potential double taxation). For many small businesses, C‑Corp taxation is less favorable for reducing self‑employment tax than an S‑Corp, but it can be useful in specific growth or exit scenarios.
S‑Corporation strategy: how savings arise (and limitations)
The S‑Corp strategy can reduce the portion of income subject to self‑employment tax by splitting owner compensation into wages (subject to payroll taxes) and non‑wage distributions (not subject to self‑employment tax). Key elements:
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Reasonable compensation: The IRS requires owner‑employees to receive a ‘‘reasonable salary’’ for services. What is reasonable depends on industry norms, duties, time spent, and comparable wages. Underpaying salary to avoid payroll taxes risks reclassification of distributions as wages and penalties. See Form 2553 and IRS guidance for elections and payroll considerations.
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Payroll and employment taxes: The S‑Corp must run payroll, with the employer paying its share of Social Security and Medicare taxes. The owner‑employee pays the employee share through withholding. Combined, these payroll taxes typically mirror the self‑employment tax rate, but the avoidance happens because distributions avoid the employee’s portion of self‑employment tax when they are treated as returns on equity rather than earned income.
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State rules: State tax treatment and state‑level payroll or franchise taxes can change the calculus. Some states require S‑Corps to pay minimum taxes or franchise fees; others treat S‑Corp distributions differently. Always check state rules before electing S‑Corp status.
Illustrative example (for explanation only)
Consider a hypothetical owner with $100,000 of net business income. If taxed as a sole proprietor, most of that income is subject to self‑employment tax, producing roughly 15.3% in payroll tax liability on the net earnings (subject to Social Security wage base limits and the Medicare surtax where applicable).
If the business elects S‑Corp status and the owner pays themself a reasonable salary of $60,000 and takes $40,000 as distributions, the owner pays payroll taxes on the $60,000 salary (both employer and employee portions) but not on the $40,000 distribution. The precise tax savings depend on Social Security wage base limits, Medicare surtax thresholds, and the employer share of payroll taxes. This example is illustrative, not tax advice; actual results vary with deductions, state taxes, retirement contributions, and other factors.
Common mistakes to avoid
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Treating distributions as a free tax shelter: Distributions must reflect real economic returns and cannot replace reasonable compensation for services performed.
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Underestimating payroll costs and compliance obligations: Electing S‑Corp status requires payroll, quarterly filings, payroll tax deposits, W‑2s, and withholding. Many small business owners underestimate the administrative cost.
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Ignoring state taxes: A federal S‑Corp election does not change state filing requirements in every state. Some states tax S‑Corp income or impose entity‑level taxes.
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Failing to pay estimated taxes: Changing entities doesn’t eliminate estimated tax obligations. Owner‑employees who receive distributions still may need to make quarterly estimated tax payments for income and payroll tax withholding shortfalls (IRS estimated tax rules apply).
When an S‑Corp may not help
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Low profits: For very small net incomes, the cost of running payroll and maintaining compliance can outweigh tax benefits.
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Passive income or limited partners: If your business is primarily passive or you are a limited partner, self‑employment tax exposure may already be limited.
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High reinvestment needs: Businesses that keep most earnings in the company or plan to grow quickly might benefit from C‑Corp taxation or simply avoid S‑Corp complexity.
Steps to evaluate and implement a change
- Run the numbers: Prepare a pro‑forma that compares net income under current classification versus an S‑Corp or C‑Corp, including payroll tax, employer payroll cost, state taxes, and administrative expenses.
- Confirm reasonable salary: Use industry salary surveys, job descriptions, and comparable positions to document how you determined a reasonable salary.
- Elect S‑Corp timely: File Form 2553 to elect S‑Corp status by the IRS deadline (typically by March 15 of the tax year for calendar year S‑Corps, or within 75 days of formation—see IRS guidance).
- Set up payroll: Implement payroll with withholding and employer tax deposits, and provide W‑2s for owner‑employees.
- Maintain records: Keep minutes, payroll records, and K‑1s (for partnerships) to substantiate allocations and distributions.
- Revisit annually: Tax laws and business circumstances change—reassess entity choice each year.
Recordkeeping and compliance
Accurate records are essential. Payroll records, board or member minutes approving compensation, expense receipts, and bank statements help defend reasonable compensation and the economic substance of distributions. The IRS has challenged S‑Corp arrangements it views as abusive; strong documentation and conservative salary decisions reduce audit risk.
Interlinks and further reading
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See our glossary entry on S‑Corporation for details about S‑Corp tax rules and common filing mistakes: S‑Corporation (https://finhelp.io/glossary/s-corporation/).
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For help understanding LLC basics and default tax classifications, see Limited Liability Company (LLC): https://finhelp.io/glossary/limited-liability-company-llc/.
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If you plan to elect S‑Corp status, review Form 2553 guidance here: Form 2553 – Election by a Small Business Corporation (S‑Corp Election): https://finhelp.io/glossary/form-2553-election-by-a-small-business-corporation-s-corp-election/.
Authoritative sources
- IRS — Self‑Employment Tax overview: https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax (accessed 2025).
- IRS — Form 2553 instructions (S‑Corp election): https://www.irs.gov/forms-pubs/about-form-2553 (accessed 2025).
Professional perspective
In my work advising self‑employed clients, I routinely see S‑Corp elections produce meaningful payroll tax savings for business owners with sustained, predictable profits above a certain threshold. However, the benefit only materializes when the owner maintains a defensible, well‑documented salary and accepts the extra administrative burden. When I model changes for clients, I include state taxes, payroll costs, retirement plan effects, and the value of employer‑paid benefits before recommending a change.
Disclaimer
This article is educational and not individualized tax or legal advice. Tax outcomes depend on your full financial picture and state rules. Consult a qualified CPA or tax attorney before changing your business entity or tax election.
