Federal taxes are a major consideration when determining how to structure your business, and many business owners choose to operate as S corporations for their tax advantages. One upside of S corporation status is keeping Social Security and Medicare taxes at manageable levels.
An S corporation owner isn’t subject to self-employment (SE) tax on his or her share of the company’s income. However, Social Security and Medicare taxes still apply to salary compensation paid to shareholder-employees. In light of this, many S corporations seek to manage their payroll tax liability by paying only modest salaries to shareholder-employees and paying out most or all of the remaining corporate cash flow in the form of payroll-tax-exempt cash distributions.
If an S corporation is audited by the IRS, the tax agency will likely pay close attention to whether salaries paid to the shareholder-employees appear to be unreasonably low to minimize federal payroll taxes. The IRS could recharacterize a portion of distributions paid to shareholder-employees as wages. It might then bill the S corporation for underpaid payroll taxes and interest — and possibly even assess penalties. Here are answers to some common questions to help you avoid this unfavorable outcome.
How Much FICA Tax Is Owed on Shareholder-Employees’ Compensation?
Social Security and Medicare (FICA) taxes on salary compensation paid to S corporation shareholder-employees are split equally between the shareholder-employees and the company (the employer). Specifically, both must pay:
- The 6.2% Social Security tax on earned income up to the Social Security tax wage ceiling, and
- The 1.45% Medicare tax on all salary income.
For 2025, the Social Security tax wage ceiling is $176,100. This ceiling is adjusted annually for inflation.
The combined total Social Security tax rate is 12.4% (6.2% withheld from salary paid to a shareholder-employee and 6.2% paid by the S corporation). The combined total Medicare tax rate is 2.9% (1.45% withheld from salary paid to a shareholder-employee and 1.45% paid by the S corporation). So, the total combined FICA tax rate on salary income up to the Social Security tax wage ceiling is 15.3% (12.4% for Social Security tax and 2.9% for Medicare tax).
A higher-income shareholder-employee must also pay the 0.9% additional Medicare tax on salary income above the applicable threshold. (There’s no employer portion of this tax.) The 0.9% additional Medicare tax generally kicks in when an individual’s salary exceeds the following:
- $200,000 for single people,
- $250,000 for married couples filing jointly, and
- $125,000 for married individuals filing separately.
S corporations that pay relatively modest, but still reasonable, salaries will keep their FICA tax obligations at a manageable level. Then, they can distribute all or part of the remaining corporate cash flow to shareholder-employees without incurring FICA tax.
For example, Barry is the sole shareholder of an S corporation. Before paying himself a salary, the company reports taxable income of $250,000. Barry decides to pay himself a modest, but reasonable, salary of $80,000. The total FICA tax obligation would be $12,240 ($80,000 times 15.3%). But FICA tax applies only to an S corporation shareholder-employee’s wages. An individual’s income from other types of pass-through business entities is subject to SE tax, which can be significantly more costly for profitable businesses. (See “FICA vs. SE Tax: What’s the Big Difference?” below.)
What’s a Reasonable Salary for an S Corporation Shareholder-Employee?
Reasonableness is in the eye of the beholder, and S corporation owners and the IRS often disagree on this issue. To avoid IRS scrutiny, S corporations must pay shareholder-employees reasonable FICA wages (including salaries and bonuses) for the services they provide to the business.
To meet the IRS reasonableness standards, start by benchmarking to learn how S corporations of similar size and financial performance in your industry and geographic region are paying their shareholder-employees. In addition, the IRS will closely examine specific factors that may be relevant. These include:
- Background, education, skills and experience,
- Specific responsibilities,
- Work hours and length of service,
- Professional reputation, and
- Customer relationships.
Other things being equal, the more these factors come into play, the higher the salary should be in the eyes of the IRS. Shareholder-employee salaries should generally be consistent from year to year, without dramatic raises or cuts. For more information, including access to market-based compensation data, contact your tax advisor.
Are There Any Side Effects from Limiting Shareholder-Employees’ Salary Compensation?
Social Security benefits are based on FICA wages. Therefore, minimizing an S corporation shareholder-employee’s salary during his or her working years will result in lower federal benefits in retirement.
Another potentially unfavorable side effect of paying a modest salary to an S corporation shareholder-employee is limitations on contributions to certain tax-favored retirement accounts. Specifically, if your S corporation has a Simplified Employee Pension (SEP) or corporate profit-sharing plan, the maximum annual deductible contribution is limited to 25% of your salary. The lower your salary, the lower the maximum contribution. However, if the S corporation sets up a 401(k) plan, paying yourself a modest salary won’t preclude making relatively generous annual deductible retirement account contributions.
Should I Convert My Unincorporated Business into an S Corporation?
S corporations offer some tax advantages compared to other unincorporated business structures, including:
- Sole proprietorships,
- Single-member limited liability companies (LLCs) that are treated as sole proprietorships for tax purposes,
- Partnerships, and
- Multimember LLCs that are treated as partnerships for tax purposes.
Operating as an S corporation can potentially reduce your overall tax obligation by reducing your Social Security and Medicare tax bills. But before electing S status, you should fully evaluate the pros and cons. For example, operating as an S corporation involves some additional administrative chores, including:
- The corporation must file annual federal income tax returns and state income tax returns (if applicable).
- You must carefully structure transactions between S corporations and shareholders, including shareholder loans and transfers of business assets to the corporation.
- You must follow state-law corporation requirements, such as conducting board meetings and keeping corporate minutes.
There may also be legal issues to consider, so always consult your legal advisor when deciding how to structure your business.
If you decide that S corp status is right for you, follow these three steps:
- Form a corporation under applicable state law,
- Transfer business assets to the new corporation, if applicable, and
- Make an S election for the new corporation by filing Form 2553, “Election by a Small Business Corporation.”
Calendar-year corporations must file Form 2553 by March 15 of the conversion year. The deadline to make an S election for calendar-year 2025 is behind us, but you can still make the election for 2026 and beyond.
Make an Informed Decision
Converting an existing unincorporated small business into an S corporation to manage Social Security and Medicare taxes can be a smart move under the right circumstances. But this isn’t a do-it-yourself project. Before implementing this strategy, consult your tax and legal advisors to evaluate all the relevant angles.
FICA vs. SE Tax: What’s the Big Difference? Like income taxes, federal payroll taxes are a fact of life. Social Security and Medicare taxes (collectively the FICA tax) are incurred on salary and bonus income. The FICA tax is split equally between the employee (including a corporate shareholder-employee), via withholding, and the employer. Uncle Sam collects Social Security and Medicare taxes in a different way from self-employed individuals. There’s no FICA tax for these people. Instead, unincorporated small business owners generally must pay self-employment (SE) tax on most or all of their passed-through shares of business profits. SE tax applies to net SE income from the following entities:
Income from these types of unincorporated businesses is passed through to the owners and reported on their personal returns. The owners must also calculate and pay any SE tax liabilities on their net SE income. The net SE income ceiling for the Social Security tax component of the SE tax is adjusted annually for inflation. For 2025, the first $176,100 of net SE income gets hit with the maximum 15.3% SE tax rate (12.4% for the Social Security tax plus 2.9% for the Medicare tax). Any additional net SE income gets taxed at the 2.9% SE tax rate for the Medicare tax. Higher-income taxpayers must also pay the additional 0.9% Medicare tax, which increases the Medicare tax rate to 3.8% (2.9% plus 0.9%). This rate generally kicks in when net SE income exceeds the following:
To illustrate, suppose you have net SE income of $176,100 for 2025. How much would you owe for the SE tax? Because your net SE income equals the Social Security tax net SE ceiling, you’d owe $26,943 for the SE tax ($176,100 times 15.3%). The next dollar of net SE income above the Social Security ceiling would be subject to only the 2.9% Medicare tax. If you’re single, the 0.9% additional Medicare tax would kick in once your net SE income exceeds $200,000. |
