The S-corporation has two checks on it, and ignoring either one is expensive.
The first is reasonable compensation. You cannot pay yourself a $10,000 salary on $500,000 of profit and distribute the rest. The IRS requires the salary to reflect what an independent employer would pay for the work the owner actually performs, and S-corporation salary is one of the agency’s standard audit targets. Defend the figure with data — compensation surveys, Bureau of Labor Statistics wage data, or a service such as RCReports — and document the reasoning before filing, not after the notice arrives. A salary set too low does not save tax; it defers a reclassification, with penalties and interest attached.
The second is the break-even point. The election is not free: it brings payroll processing, a separate corporate return, and, in many states, entity-level fees. California is the cautionary example — an S-corporation there pays an $800 minimum franchise tax and a 1.5% tax on net income, on top of payroll administration. As a rule of thumb, the arbitrage does not cover its own overhead until net profit clears roughly $80,000 to $100,000; below that, the friction eats the saving.
Consider a consultant whose practice nets $350,000 before any owner compensation. As a sole proprietor, that $350,000 is self-employment income; after the 92.35% adjustment, the self-employment tax lands near $32,000. Elect S-corporation status and the same $350,000 splits: a $140,000 salary — reasonable for a consultant’s work — and a $210,000 distribution. Payroll taxes on the $140,000 total roughly $21,000; the $210,000 distribution carries none. The gap, on the order of $10,000 a year, is the arbitrage. It is real — but California’s $800 franchise tax and 1.5% entity tax claw back a meaningful slice, which is exactly why the break-even sits where it does.