Business Owners should use all S Corporation Tax Benefits… if an S-Corp makes sense.

An S corporation is not a separate tax. It is a way of being taxed: the company pays no federal income tax itself, and profit, losses, deductions and credits pass through to the owners' personal returns. The savings come from how you split your income between salary and distributions, and from a set of deductions and plans that are easier to use inside a corporation. This guide covers each benefit, the rules that limit it, and how to avoid the mistakes that cause audits.

This is general information, not tax advice. Reach out to Scorpio Tax via tax@S-CorpTax.com if you would like support.

1. The core benefit: payroll tax savings

A sole proprietor or partner pays self-employment tax (15.3% on income up to the Social Security wage base, then 2.9% Medicare above it, plus 0.9% Additional Medicare over $200,000 single / $250,000 joint). An S corporation owner who works in the business must take a reasonable salary, which is subject to payroll tax. Remaining profit is paid as a distribution, which is not subject to payroll tax.

Illustrative example, $300,000 of net profit:

• Sole proprietor: roughly $30,900 of self-employment tax.

• S corporation with a $120,000 salary: roughly $18,400 of payroll tax (employer and employee halves combined).

• Gross savings: about $12,500 per year, before the added costs below.

Above the Social Security wage base (about $184,500 in 2026), each extra dollar moved from salary to distribution saves only the 2.9% Medicare tax, so the benefit grows more slowly at high income. Active S corporation income is also generally exempt from the 3.8% net investment income tax.

2. Is it worth it? The break-even

Costs of an S corporation include payroll processing, a separate corporate tax return (Form 1120-S), more bookkeeping, possible state entity taxes, and a CPA who knows the rules. These typically run several thousand dollars a year.

Rules of thumb:

• Under roughly $60,000-$80,000 of net profit, the savings often do not cover the costs.

• From about $100,000 up, the election usually pays off.

• If nearly all your profit would have to be paid as salary (for example, a one-person consulting firm with no capital), the savings shrink.

• If you hold investments, real estate or passive assets in the entity, an S corporation may be the wrong vehicle.

3. Eligibility and how to elect

To be an S corporation you must:

• Be a domestic corporation or an LLC that elects corporate treatment.

• Have no more than 100 shareholders, all of them individuals, certain trusts or estates (no partnerships or corporations, no nonresident aliens).

• Have one class of stock, with identical rights to distributions.

File Form 2553 no later than two months and 15 days after the start of the tax year the election takes effect. If you miss the deadline, Revenue Procedure 2013-30 offers late-election relief, generally available within three years and 75 days of the intended effective date, if you can show reasonable cause and have filed consistently as an S corporation. OBBBA did not change this procedure.

4. Reasonable compensation: the rule that governs everything

The IRS requires an owner-employee to be paid reasonable pay for services before taking distributions. Paying yourself a tiny salary and large distributions is the most common S corporation audit issue, and courts have recharacterized distributions as wages with penalties and interest.

How to set it defensibly:

• Benchmark what a comparable business would pay someone for the same work. Use salary surveys, job postings and industry data, and keep the file.

• Consider your hours, duties, training, revenue generated and what you would pay a replacement.

• Pay yourself regular wages through payroll, with withholding and quarterly filings.

• Revisit the number yearly. Salary should rise as the business grows.

There is no safe-harbor percentage. A salary near 40-60% of profit is common for service businesses, but the right figure depends on your facts.

5. The QBI deduction (Section 199A)

Pass-through owners can deduct up to 20% of qualified business income. OBBBA made the deduction permanent, removing the 2025 sunset.

How it interacts with salary:

• Your own W-2 salary is not qualified business income, so a higher salary lowers the QBI base.

• Above the income thresholds (about $201,750 single / $403,500 joint for 2026), the deduction is limited to the greater of 50% of W-2 wages paid, or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property. A higher salary can therefore increase the allowed deduction.

• Specified service trades or businesses (health, law, accounting, consulting, financial services, and similar) lose the deduction as income rises through the phase-out range.

Model several salary levels. The best answer balances payroll tax, QBI and retirement contributions, and it changes as income grows.

6. Retirement plans

An S corporation can sponsor a 401(k) with both an employee deferral and an employer contribution. The employer contribution is calculated on W-2 wages only, not on distributions, so salary directly sets how much you can contribute.

Approximate 2026 limits (confirm current figures):

• Employee deferral: $24,500, plus catch-up contributions if you are 50 or older.

• Total employee plus employer limit: $72,000, before catch-up.

• Employer profit-sharing contribution: generally up to 25% of W-2 compensation.

High earners who want to shelter more can add a cash balance or defined benefit plan, which can allow well over six figures a year in deductible contributions. These require an actuary, annual funding and are a long-term commitment. Plan documents must be in place and contributions timed correctly, so set them up before year-end.

7. Health insurance and HSAs

For shareholders who own more than 2% of the company, health insurance gets special treatment:

1. The S corporation pays the premiums, or reimburses you under a documented arrangement.

2. The premiums are added to your W-2 as wages (box 1, not boxes 3 and 5, so no Social Security or Medicare tax).

3. You then claim the self-employed health insurance deduction on your personal return, limited to your earned income from the S corporation.

The net effect is that premiums are deductible above the line. If the company pays premiums but fails to put them on your W-2, the deduction can be disallowed.

HSA contributions work similarly: employer contributions for a more-than-2% shareholder are treated as wages, then deducted on your personal return, without payroll tax savings. 2026 limits are about $4,400 self-only and $8,750 family. The policy itself should be real, ACA-compliant coverage, not a limited benefit or fixed indemnity plan.

8. Accountable plans and business expense reimbursement

As an employee, you cannot deduct unreimbursed business expenses personally. An accountable plan lets the corporation reimburse you tax-free, as long as you:

• Document the business purpose.

• Submit substantiation (receipts, mileage logs).

• Return any excess advance.

Common uses: home office costs, business mileage, cell phone and internet, professional dues and software. Without a written plan, reimbursements risk being treated as taxable wages.

Some owners also rent their home to the corporation for up to 14 days a year for meetings (the Section 280A(g) "Augusta rule"). The rent is deductible by the company and tax-free to you, but it requires fair-market-value support, a written agreement, minutes and real use. Treat it as an audit-sensitive strategy.

9. Depreciation and equipment expensing

OBBBA made 100% bonus depreciation permanent for qualifying property acquired after January 19, 2025, and raised the Section 179 expensing limit (about $2.56 million for 2026, with a phase-out for large purchases). Equipment, vehicles, computers and qualified improvements can often be deducted in the year placed in service.

Cautions:

• Heavy vehicles have special limits, and passenger vehicles face luxury-auto caps.

• Only business-use percentage is deductible. Keep a mileage log.

• Deducting everything at once creates lower deductions later. Match depreciation to your expected income.

• Sections 179 and bonus depreciation cannot create more loss than your basis allows (see section 12).

10. The SALT cap and the pass-through entity tax (PTET)

The personal state and local tax deduction cap rose to $40,000 in 2025 and about $40,400 in 2026, indexed through 2029 and reverting to $10,000 in 2030. It phases down for taxpayers with modified adjusted gross income above roughly $505,000, to a floor of $10,000.

Most states, including California, let an S corporation elect to pay state income tax at the entity level. The entity-level tax is deductible in computing federal business income, outside the personal SALT cap, and owners generally receive a credit on their state return. This can save significant federal tax for high earners in high-tax states.

California's PTET (originally AB 150, since extended) is an annual election made on a timely filed return. The entity pays 9.3% of qualified net income, with a required June 15 payment of the greater of 50% of the prior year's PTE tax or $1,000. Confirm the program's current rules and sunset date before electing. A missed payment can forfeit the credit.

11. California-specific costs

California does not follow the federal S corporation model completely:

• California taxes S corporations at 1.5% of net income, with an $800 annual minimum franchise tax.

• An LLC that elects S status also owes the California LLC gross-receipts fee.

• California does not conform to the federal QBI deduction, so there is no state-level 20% deduction.

• PTET, if elected, is paid in addition to the 1.5% tax.

These costs reduce the net payroll tax savings in California. Run the full comparison before electing.

12. Basis, losses and distributions

Track three layers of basis: stock basis (what you invested plus income retained), debt basis (loans you made directly to the company) and at-risk and passive loss limits.

• Losses are deductible only up to your basis. Excess is suspended.

• Distributions beyond stock basis are taxed as capital gain.

• Distributions must be pro rata to ownership. Disproportionate distributions can create a second class of stock and terminate the election.

• A guarantee of company debt does not by itself increase basis. A direct loan from you does.

Keep a yearly basis schedule. It is not on the K-1 and is the shareholder's responsibility.

13. Selling or converting

• If you convert from a C corporation, built-in gains tax can apply to appreciation that existed at conversion, generally for five years.

• S corporation stock cannot qualify for Section 1202 qualified small business stock treatment, which requires C corporation stock. If a future sale to a buyer or a large exit is your goal, compare structures before electing.

• Asset sales and stock sales are taxed differently. Allocation of purchase price among assets matters.

14. Mistakes that create audit problems

• A salary far below market, or no salary at all.

• Paying personal expenses from the company account without treating them as wages or distributions.

• Failing to run payroll on time or file quarterly returns.

• Skipping the W-2 treatment for owner health insurance.

• Disproportionate distributions or paying distributions without basis.

• No formal minutes, no separate bank account, mixing business and personal funds.

• Ignoring state-specific filing and PTET deadlines.

The benefits can be significant, but depend on details. Not all LLCs and C-Corps should make an S-Corp election.

Work with Scorpio Tax, your S corporation specialist, before electing, since errors are expensive to correct.

Reach us at tax@S-CorpTax.com.