Business Structures · Section E
When to switch from sole prop to S-corp.
The math everyone references but few actually run. Here's the formula, the threshold, and the situation where switching too early costs you money.
Plainly stated — "Should I be an S-corp?" is one of the most-asked questions I get from clients and members. The honest answer is: it depends, and the decision is mostly math. Here's the math.
The core mechanic
As a sole proprietor, every dollar of profit is subject to self-employment tax (15.3% up to the Social Security wage base, then 2.9% Medicare on top, plus 0.9% additional Medicare on high earners). All of it.
As an S-corp, you pay yourself a "reasonable salary" — that part is subject to payroll tax. The remaining profit flows through as a distribution, which avoids self-employment tax entirely. That's the savings.
The simple formula
The savings roughly equals: (Profit − Reasonable Salary) × 15.3%. So if your business profits $150K and a reasonable salary in your role is $80K, the savings are roughly $10,710 ($70K × 15.3%) — minus the costs of running the S-corp (payroll service, extra tax prep, state fees).
The rough threshold
For most businesses, S-corp election starts paying off around $60K–$80K of net profit. Below that, the administrative cost of running the corp eats the savings. Above that, the savings climb fast.
When NOT to switch
The S-corp election isn't free. Watch out for:
- Inconsistent or seasonal income. If your profit swings wildly year to year, payroll mechanics get awkward.
- You want to bring on outside investors. S-corps have ownership restrictions C-corps don't.
- Your reasonable salary is most of your profit. If your role pays $130K and the business profits $150K, the math gets thin.
- You're maxing out QBI. The 20% qualified business income deduction interacts with wage thresholds — the calculus changes for high earners in service businesses.
The "reasonable salary" trap
Some operators set the salary too low to maximize distributions. The IRS notices. Audit risk is real here, and the penalty for getting caught is back-payroll-tax plus interest plus a potential reclassification of distributions as wages.
The "reasonable salary" should reflect what someone would pay you to do your role at arm's length. Your CPA should help you defend the number with comparable salary data and a written rationale.
The Prosperity Society membership has a full module on corporate structures with the deeper version of this — including the salary-defense template, multi-year switch modeling, and when to consider a holding company on top.