Stay Ahead of Law Changes & Protect Yourself Against Being Audited: Corporate Transparency Act and Reasonable Compensation

Cut Your Self Employment Tax With an S-Corporation

Have you had enough of paying large amounts of self-employment tax? 

For 2022, lawmakers levy the self-employment tax at the painfully high rate of 15.3 percent on the first $147,000 of net self-employment income. This 15.3 percent includes the Social Security tax of 12.4 percent and the Medicare tax of 2.9 percent. While you know all this already, it is important to take a look at it again. This will allow you to gauge how serious the situation is. 

Also, the tax ceiling of $147,000 for the Social Security tax is an increase from $142,800 for the tax year 2021. And this tax ceiling is expected to rise! 

There is an additional 0.9 percent tax rate on Medicare tax that takes it to 3.8 percent for earners above $200,000 or $250,000, depending on whether you are married or not. 

It is obvious that your self-employment tax is a large chunk of your income. However, you can cut your self-employment tax with an S corporation. We will be looking at how you can do this below. 

Looking at Federal Employment Taxes for S Corporation Employees 

For the 2022 tax year, the FICA tax rate for an S corporation employee is 7.65% on the first $147,000. This rate remains even if the employee is a shareholder. 

7.65 percent is made up of: 

  • 6.2 percent as Social Security tax. 
  • 1.45 percent as Medicare tax. 

The FICA tax rate drops to 1.45 percent above the $147,000 because of the removal of the Social Security tax. However, the 1.45 percent Medicare contribution remains, and for high earners, it rises to 2.35 percent due to an additional 0.9 percent. 

The S corporation employer also must pay the same 6.2 percent Social Security tax and 1.45 percent Medicare tax as the employee. This makes the total 12.4 percent for the Social Security tax and 2.9 percent for the Medicare tax, which increases to 3.8 percent for high earners. 

Although this is the same rate as the self-employment tax, the good thing is that only the W-2 wages paid to the employee are affected by federal employment taxes. 

This means that the S corporation removes the W-2 wages. After this, the shareholder-employee receives the remainder of the taxable income and reports this income on his Form 1040. Finally, the corporation distributes cash to the shareholders as a dividend payment. 

There is no employment tax on dividend payments. However, the IRS requires shareholder-employees to collect a “reasonable salary” before sharing dividends. 

Take Note of the Side Effect on Retirement Plans 

It is important to note that if you run your business as an S corporation and pay yourself a small salary, it can affect the amount you are able to deduct from your tax-favored retirement account. 

This is because the smaller the salary, the smaller the maximum deductible retirement contributions. If your S corporation still uses a standard profit-sharing plan or a SEP, a shareholder-employee can only deduct up to 25% of their salary. 

However, you can fix this by making your S corporation set up a 401(k) plan. This ensures that the salaries do not affect retirement contributions. 

How to Convert Your Businesses into S Corporations 

For federal tax purposes, you do not need to go through legal steps to convert your existing domestic LLC business to an S corporation. 

The IRS gives single-member LLC and multi-member LLC entities the flexibility to choose S corporation status when they fill out Form 2553. However, they must fill out the form no more than 2 months and 15 days after the beginning of the tax year or after the date the entity comes into existence. 

If the LLC is new, you have two months and 15 days from the date the newly formed entity comes into existence to file Form 2553.  

To convert an existing sole proprietorship or partnership into an S corporation, you will have to form a corporation that meets state laws and contribute your business assets to the newly formed corporation. Then you can make an S election by filing Form 2553 no more than 2 months and 15 days later. 

Does it Matter that the IRS Understands How This Works? 

The IRS is aware of this tax savings strategy, so it is important that you take this step with a qualified tax planning expert to help guide you. 

If the government can prove that the cash distributions the S corporation pays to you are salaries, then the corporation will be hit with interest, penalties, and back employment taxes. So, it is important to make sure to keep shareholder-employee salaries reasonable.  

Can You Use a C Corporation? 

Like an S corporation, federal payroll tax is only due on compensation payments made to a shareholder-employee of a C corporation. Unlike S corporations, however, C corporation payouts, such as dividends, are taxable and subject to double taxation. This means that the dividend amounts are taxed at both the corporate level and the shareholder level. 

Therefore, it is not advisable to use a C corporation, especially when most or all of the corporate cash flow is paid to shareholders. 


The major issue to take note of is the payment of an unreasonably low salary to shareholder-employees of S corporations. So, it is better to keep the salaries modest. 

Also, know that there are a few other tax issues that come with operating as an S corporation. 

This includes: 

  • You will have to file an annual federal income tax return on Form 1120-S and sometimes a state income tax return as well. 
  • For tax purposes, all the transactions between the S corporation and its shareholders will be carefully examined. 
  • While satisfying state law corporation requirements, you must keep minutes of all board of director’s meetings. 

Operating an S corporation is not smooth sailing. But it is worth it when you consider the amount you save on federal employment taxes. 

1. ($147,000 x .124) + [($200,000 x .9235) x .029] = $23,584. 

2. Rev. Rul. 59-221; Paul B. Ding v Commr., 84 AFTR 2d 99-7517 (9th Cir. 1999)

3. IRC Section 162(l)

4. Per IRS Revenue Ruling 91-26, the company-paid medical insurance premiums are considered taxable compensation that’s not subject 

to federal employment taxes as long as the guidelines in IRS Announcement 92-16 are met. 

5. Per IRS Rev. Rul. 91-26, the company-paid medical insurance premiums are considered taxable compensation that’s not subject to federal employment taxes as long as the guidelines in IRS Announcement 92-16 are met. 

6. See Reg. Section 301.7701-3(c)(1)(v)(C) and the instructions to Form 8832, Entity Classification Election (Rev. December 2013). See also Reg. Section 301.7701-3(g) for the steps that are deemed to occur when the conversion to S corporation status becomes effective. 

7. For examples see Joseph Radtke, S.C., 65 AFTR 2d 90-1155 (7th Cir. 1990); Veterinary Surgical Consultants, P.C., 93 AFTR 2d 2004-1273 (3rd Cir. 2004); and David E. Watson, P.C., 107 AFTR 2d 2011-311

8. Carol Davis, d/b/a Mile High Calcium, Inc., 74 AFTR 2d 94-5618

9. EY Tax News Update 2021-1601, Sep. 7, 2021

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