Reasonable Compensation and the Break-Even Point

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 contemporaneously before filing instead of scrambling after a 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 the greater of an $800 minimum franchise tax or 1.5% of 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.

Work through the exact arithmetic instead of relying on a crude rule of thumb. Consider a single-filer consultant whose practice nets $350,000 before any owner compensation. As a sole proprietor, that $350,000 is self-employment income. Self-employment tax runs on 92.35% of net profit, with Social Security stopping at the wage base and Medicare running without limit:

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. The salary sits below the wage base, so it carries the full 15.3%; the distribution carries nothing:

That gap is the arbitrage, and it is real. California then takes its cut, and the base deserves a sentence: the corporation’s taxable net income is the profit after both the $140,000 salary and the deductible employer half of the payroll tax ($10,710) — about $199,300, not the full $210,000 distributed. The 1.5% franchise tax on that is roughly $2,990, which exceeds the $800 minimum, so $2,990 is what you owe — the $800 functions as a minimum floor, not an additional surcharge. Net the state tax against the $11,941 and roughly $8,950 survives, before payroll service and the extra return preparation. Two second-order terms cut against the election and belong on any realistic ledger. The sole proprietor deducts half the SE tax above the line under IRC §164(f) — $16,126 here, half of the Social Security and regular Medicare tax, since the 0.9% surtax is excluded from the deduction — against the corporation’s deductible employer half of $10,710, and at a 35% marginal rate that $5,416 of lost deduction claws back roughly $1,900 of the saving. And Social Security benefit formulas credit W-2 salary, not partnership or S-corp distributions: covered earnings drop from the $184,500 wage base to $140,000, which trims the eventual benefit — modestly, since dollars above the second bend point accrue at fifteen cents on the dollar, but a career of lower covered wages is not zero. A third term is retirement room. The employer contribution to a Solo 401(k) is 25% of W-2 salary for an S-corporation owner but 20% of net earnings for a sole proprietor (section “Solo 401(k) plans”), so the $140,000 salary caps the employer contribution at $35,000 where the sole proprietor could have put in $47,500 — the balance of the $72,000 limit after the $24,500 deferral. That is $12,500 of pre-tax deferral the election costs an owner who would have used it. Net the first term and the $8,950 is closer to $7,050. The corporation’s $2,990 of California tax is itself federally deductible, worth about $1,050 back, so call it $8,100 before compliance costs — and less for an owner who fills the plan. Rerun the same computation at $120,000 of profit with a $90,000 salary and the gross saving falls to about $3,200 — against the $800 minimum tax and one to three thousand dollars of payroll and compliance cost, the election is a wash or worse. That is the break-even, and it moves with your state and your salary ratio — which is why it requires dynamic computation instead of a memorized rule of thumb.