Could an S Corp Cut Your Tax Bill?

Imagine this: You’re a hardworking business owner running a profitable business. You’ve heard that switching to an S corporation could save you money on taxes, but is it really the right move for you? Let’s break it down with a real-world example.

The Self-Employment Tax Dilemma

Meet John. He’s been operating his consulting business as a sole proprietorship for years, reporting $100,000 in net income annually. As a sole proprietor, John pays self-employment taxes on the full $100,000, which costs him about $15,300 in Social Security and Medicare taxes alone.

One day, John hears that forming an S corporation could help him save on self-employment taxes. He makes the switch and sets his salary at $40,000. Now, he only pays self-employment taxes on his salary, while the remaining $60,000 flows through to him as profit distributions—completely avoiding self-employment taxes. Just like that, John saves over $8,000.

Sounds great, right? Well, before you rush to form an S corporation, let’s talk about what else you need to consider.

S Corporation Hidden Costs and State Taxes

John’s friend, Lisa, also switched to an S corporation but lives in California. She was thrilled about the tax savings until she realized that California imposes an $800 minimum tax on S corporations, plus a 1.5% state tax on corporate income. After factoring in these additional costs, her savings weren’t as high as she expected.

And it’s not just California. Some states apply a franchise tax to S corporations. The bottom line? State taxes can eat into your savings, so you need to do the math.

Paying Yourself the Right Salary

Now, let’s talk about salary. The IRS requires that you pay yourself "reasonable compensation" for the work you do in your S corporation.

Consider Mike. He’s an S corporation owner who tried to game the system by taking a $10,000 salary while pulling $90,000 in profit distributions. The IRS didn’t buy it. They audited him, reclassified much of his distributions as salary, and hit him with back taxes and penalties.

On the other hand, Sarah, another S corporation owner, took a salary of $160,000 and received $150,000 in profit distributions. Because her salary was already above the Social Security tax limit, she only saved on Medicare taxes. But when she factored in state taxes and corporate filing fees, she actually ended up paying more in taxes than if she had stayed a sole proprietor. Ouch!

Other Considerations Beyond Taxes

Switching to an S corporation isn’t just about taxes—it changes how you handle business finances:

• Retirement Contributions – Your solo 401(k) contributions are based on salary. A lower salary means lower retirement savings potential.
• Medical Reimbursements – Proprietors can use a Section 105 medical reimbursement plan to cover out-of-pocket healthcare expenses tax-free. S corporation owners can’t.
• Hiring Your Kids – If you pay your under-18 children through a proprietorship, their wages aren’t subject to payroll taxes. With an S corporation, you lose that benefit.

These little details matter—something you can discuss during a CPA free consultation with a professional who knows the ins and outs of small business tax strategies.

The Paperwork Factor

An S corporation also means more paperwork. You need to:

• Keep corporate records and minutes
• File a separate corporate tax return
• Maintain a clean separation between personal and business finances

Failing to do these things can put your S corporation status at risk—and that’s a mess you don’t want. If the paperwork feels overwhelming, connecting with a Houston CPA firm can make the process manageable.

The Bottom Line

Is an S corporation right for you? It depends.

• If you’re making good money and want to reduce self-employment taxes while paying yourself a reasonable salary, it could be a smart move.
• If you live in a state with high S corporation taxes or plan to take a low salary, the savings may not be worth the hassle.

Before making the switch, sit down with your CPA and do a side-by-side comparison of your actual after-tax cash flow. That’s the real number that matters.

At the end of the day, an S corporation can be a great tool—just make sure it’s working for you, not against you.

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Not sure if an S corp is right for you? Let’s talk.

We’re a Houston CPA firm who helps small business owners make smart tax moves. Book a free, no-pressure chat—we’ll see what works best for you.