What an S-Corp Election Is Actually Worth
It saves payroll tax, not income tax
Electing S-corp status does not lower your income tax. Your profit is taxed to you either way — it passes through to your personal return in both cases. What changes is payroll tax. You split the profit into a salary, which carries the full 15.3% FICA, and a distribution, which carries none.
Two things limit how much that is worth. The first is the Social Security wage base: below it you save the full 15.3% on distributions, but above it Social Security has already stopped and the saving on further distributions is only the 2.9% Medicare portion. A very high earner taking a salary at or above the wage base saves much less per dollar than the headline rate suggests.
The second is the qualified business income deduction. W-2 wages you pay yourself are not qualified business income, so electing S-corp status shrinks your §199A deduction and your federal income tax goes up. The larger the salary, the more of the deduction disappears. On $120,000 of profit with a $60,000 salary the deduction falls by roughly $8,000, which costs about $2,600 in extra income tax and takes back a third of the payroll tax saved. The calculator above shows both figures.
A reasonable salary is required
You cannot pay yourself $0 and take everything as distribution. The IRS requires reasonable compensation for the work you actually do, and officer compensation on S-corp returns is a known IRS enforcement focus. There is no safe formula: reasonableness is judged on your duties, hours, experience, and what comparable roles pay in your market. Treat any rule of thumb you have read — a percentage split, a round number — as a starting point for a conversation with an accountant, not a figure to file.
Note which way the incentive runs. A lower salary saves more payroll tax, and is also exactly what draws scrutiny and costs you more of the QBI deduction.
The costs that eat the saving
Running payroll for yourself means a payroll service, commonly $500–$1,500 a year; a separate corporate return on Form 1120-S; quarterly federal and state payroll filings; and usually an accountant who charges more than they did for a Schedule C. The calculator assumes $1,200 a year for all of it — substitute your own quotes.
Below roughly $40,000–$50,000 of profit these costs routinely exceed the payroll tax saved, and the honest answer is not to elect.
In California, subtract more
California recognises the federal election but taxes the entity anyway: 1.5% of California net income, with a minimum of $800 a year. The $800 minimum is waived for a corporation's first taxable year, though the 1.5% still applies to first-year income.
The 1.5% applies to what is left after your salary and the employer's share of payroll tax, not to total profit. On $120,000 of profit with a $60,000 salary, entity income is about $55,400 and the franchise tax is about $831 — not the $1,800 you would get by applying 1.5% to the whole profit.
Whether that $831 is a new cost depends on what you run today. Most California freelancers considering the election are already an LLC paying the $800 annual tax, so the incremental cost is small — around $31 in that example. A sole proprietor pays the whole $831 as new. One more thing for an LLC: if your gross receipts reach $250,000 you also pay California's LLC fee, which starts at $900 and rises in steps — an S-corp does not pay that, which cuts the other way.
California also does not conform to §199A. The QBI deduction reduces your federal taxable income and does nothing to your California bill.
Frequently Asked Questions
At what profit does an S-Corp start to make sense?
There is no single threshold, because it depends on your salary, your state and what compliance costs you. The pattern is that below roughly $40,000-$50,000 of net profit the payroll and filing costs exceed the payroll tax saved. Use the calculator with your own numbers and your own quotes rather than a rule of thumb, and note that the net figure it shows is already after the QBI deduction you give up.
Why does my income tax go up when I elect S-corp status?
Because wages you pay yourself are not qualified business income. The §199A deduction is 20% of QBI, and moving profit into a W-2 salary moves it out of QBI, so the deduction shrinks. The payroll tax saving is usually larger than this effect, but not always, and it is why the headline payroll tax figure overstates the real benefit.
Do distributions avoid income tax?
No. Distributions avoid payroll tax. The profit still passes through to your personal return and is taxed as income whether you take it as salary, as distribution, or leave it in the company.
What are the ongoing costs?
Formal payroll (payroll services commonly run $40-$100 a month), a separate Form 1120-S return, quarterly federal and state payroll filings, and higher accountancy fees. In California, add the 1.5% franchise tax on entity income with its $800 minimum.