The S-Corp election lets a profitable self-employed owner split income into two streams: a reasonable W2 salary, which is subject to payroll tax, and a distribution of remaining profit, which is not. That second stream is where the savings come from.
The mechanics
A sole proprietor or single-member LLC pays 15.3% self-employment tax on essentially every dollar of net business profit. An S-Corp owner pays payroll tax only on their W2 wages. If a contractor with $150,000 in net profit takes a $70,000 "reasonable salary" and distributes $80,000, the $80,000 escapes the 15.3% SE tax — saving roughly $12,240 before considering payroll service and compliance costs.
What counts as a reasonable salary?
The IRS requires S-Corp owners to pay themselves a "reasonable" wage for the work they perform. Pay too little and you invite an audit. The benchmark depends on industry, geography, and the owner's role — a software consultant in a major metro is generally expected to draw a higher salary than a part-time bookkeeper in a rural market.
The real costs to weigh
S-Corp status is not free. Expect to pay for a separate payroll service ($600–$1,200/year), a separate corporate tax return (Form 1120-S, typically $500–$1,500), and state franchise taxes in some jurisdictions. As a rough threshold, S-Corp election starts to clearly pay off once net profit exceeds about $50,000 and is highly favorable above $75,000.
The retirement stacking advantage
S-Corp owners can layer a Solo 401(k) on top of their W2 wages, contributing the $23,500 employee deferral plus a 25% employer match on their salary. For a $70,000 reasonable salary, that is up to $41,000 in retirement contributions — pre-tax, and stacked on top of the SE tax savings.