How Switching to an S Corporation Can Lower Your Self-Employment Tax Bill
Posted by Kathryn Mellon on August 20, 2025
If you're a small business owner operating as a sole proprietor, partner, or LLC, you may be feeling the sting of high self-employment (SE) taxes. Fortunately, there's a strategic way to reduce your tax burden: converting your business to an S corporation.
Understanding Self-Employment Tax
Self-employment tax applies to income from sole proprietorships, partnerships, and LLCs taxed as such. In 2025, the federal SE tax rate is 15.3% on the first $176,100 of net SE income—12.4% for Social Security and 2.9% for Medicare. Above this threshold, the Social Security portion drops off, but the Medicare tax continues at 2.9%, increasing to 3.8% for higher earners due to an additional 0.9% Medicare tax.
Thresholds for the additional Medicare tax:
- $200,000 for singles and heads of households
- $250,000 for married couples filing jointly
- $125,000 for married couples filing separately
The S Corporation Advantage
By converting to an S corporation, you can potentially reduce your SE tax liability. Here’s how:
- Pay yourself a reasonable salary: This salary is subject to employment taxes.
- Take distributions: Remaining profits can be distributed to shareholder-employees free of federal employment taxes.
This structure allows you to avoid employment taxes on a portion of your income—something not possible with sole proprietorships, partnerships, or LLCs taxed as such.
Important Considerations
While the tax savings can be significant, switching to an S corp isn’t right for everyone. Here are a few caveats:
- Salary must be reasonable: The IRS requires that shareholder-employees receive fair compensation. Underpaying yourself can trigger audits and penalties. Use market data to justify your salary.
- Impact on retirement contributions: Lower salaries can reduce your ability to contribute to SEP or profit-sharing plans, which are based on a percentage of salary. However, 401(k) plans offer more flexibility and may allow generous contributions even with modest salaries.
- Administrative complexity: S corps require separate federal (and possibly state) tax filings, formalities like board meetings, and careful handling of asset transfers and shareholder transactions.
How to Convert
To make the switch:
- Form a corporation under state law.
- Transfer business assets to the new entity.
- File IRS Form 2553 to elect S corp status by March 15 of the year you want the election to take effect.
If you're operating as an LLC, you may not need to incorporate. The IRS allows eligible LLCs to elect S corp status by filing the same form, provided it's done by the March 15 deadline.
Final Thoughts
Converting to an S corporation can be a smart move to reduce federal employment taxes, but it’s not a one-size-fits-all solution. The decision involves legal, financial, and operational considerations. Before making the switch, consult with Lumsden McCormick to ensure it aligns with your business goals.
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Katie joined Lumsden McCormick with nearly fourteen years of experience specializing in corporate and personal tax returns, preparation of financial statements, and managing accounting services for a variety of entities. She assists clients with the financial and operational management of day to day business.