How Switching to an S Corporation Can Lower Your Self-Employment Tax Bill

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:

1. 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.
2. 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.
3. 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.