SOLE PROPRIETOR S-CORP ELECTION SPLIT INCOME (Schedule C) ═══════════════════ ───────────────── ───────────────── ──╲ ╱── SALARY: $90K • $200K net income ───╲ ┌─────────────┐╱─── (subject to FICA) • ALL subject to ────╳─│ S-CORP 1120S │─╳── 15.3% SE tax ───╱ └─────────────┘╲─── DISTRIBUTIONS: $110K • Tax: $24,500+ ╱ ╲ (NO FICA tax) WITHOUT S-CORP: THE SPLIT: WITH S-CORP: ───────────────── ═══════════════════ ───────────────── • $200K × 15.3% • Salary must be • Salary: $90K = $24,500 SE tax "reasonable" • FICA on $90K only • No splitting • Rest = distribution • SE tax: ~$13,770 • Full FICA burden • 2553 election form • Savings: ~$10,730/yr ──────────────────────────────────────────────── THE MATH: Sole Prop SE tax: $200K × 92.35% × 15.3% = $28,260 S-Corp FICA tax: $90K × 15.3% = $13,770 Annual savings: $14,490 10-year savings (invested at 7%): $200,000+
FADE IN: A fluorescent-lit IRS audit room. AGENT PATRICIA DELMORE (50s, reading glasses, has audited 3,000 returns and seen every trick) sits across from TANYA RIVERS (35, freelance UX designer, terrified) and her CPA, GLEN NAKAMURA (40s, calm, folder of documentation at the ready). AGENT DELMORE Ms. Rivers, you filed an S-Corporation return last year. Your corporation paid you a salary of $90,000 and distributed $110,000 in profits. Your total net income was $200,000. TANYA (nervously) Correct. AGENT DELMORE My question is simple: why isn't all $200,000 subject to employment taxes? GLEN (opening his folder) Because the tax code specifically allows it, Agent Delmore. And we can demonstrate exactly why $90,000 is a reasonable salary for Ms. Rivers's services.
GLEN Let me back up. Before Tanya elected S-Corp status, she was a sole proprietor filing Schedule C. Every dollar of her $200,000 net income was subject to self-employment tax — that's 15.3% combining Social Security (12.4%) and Medicare (2.9%). He shows the calculation: GLEN (CONT'D) $200,000 times 92.35% — that's the self-employment tax base — times 15.3% equals $28,260 in SE tax. On top of regular income tax. That's before she buys groceries or pays rent. AGENT DELMORE Self-employment tax funds Social Security and Medicare. Everyone pays it. GLEN Employees pay 7.65% and their employer pays 7.65%. That's fair — the employer is matching. But a sole proprietor pays BOTH halves. And for someone earning over $160,000, the Social Security portion phases out but Medicare continues. The structure creates an enormous burden on successful freelancers. He pulls out a document. GLEN (CONT'D) Section 1361 allows a single-member LLC to elect to be treated as an S-Corporation. When it does, the owner pays herself a reasonable salary — which IS subject to employment taxes — and takes the remaining profit as a distribution, which is NOT subject to employment taxes. This is how Congress structured it.
AGENT DELMORE And who decides what's "reasonable"? GLEN Case law, industry data, and IRS guidance. The standard comes from Revenue Ruling 59-221 and multiple Tax Court cases. A reasonable salary is what you'd have to pay an unrelated employee to do the same work. He pulls out salary data. GLEN (CONT'D) Tanya is a senior UX designer in the Phoenix metro area with eight years of experience. Bureau of Labor Statistics data shows the median salary for this role is $85,000 to $105,000. We chose $90,000 — right in the median range. AGENT DELMORE Why not $70,000? GLEN Because that would be below market and invite exactly this audit. We WANT to be defensible. A reasonable salary isn't the minimum you can get away with — it's the amount that makes an auditor nod and move on. TANYA (to Glen, whispering) Is this going okay? GLEN (whispering back) We're doing great. This is exactly what we prepared for.
Glen lays out a series of documents. GLEN Agent Delmore, here's our supporting documentation. First: three comparable salary surveys from Glassdoor, BLS, and Robert Half's 2023 salary guide. All show senior UX designers in this market earning $85K-$110K. He turns the page. GLEN (CONT'D) Second: Tanya's corporate minutes establishing her compensation. The S-Corp held a board meeting — her as sole director — and documented the salary determination with these market comparisons attached. AGENT DELMORE (taking notes) GLEN Third: her W-2 showing $90,000 in wages. All payroll taxes were paid — employer and employee portions. FICA, FUTA, state unemployment. Everything withheld and remitted on time. He pulls one more document. GLEN (CONT'D) Fourth: the Form 1120-S showing net corporate income of $200,000, officer compensation of $90,000, and the remainder distributed as an ordinary distribution reported on her K-1. AGENT DELMORE (reviewing the documents) You came prepared. GLEN Ms. Rivers pays me to be prepared. That's why she won't have a problem today.
AGENT DELMORE Walk me through the tax difference. GLEN Gladly. Under sole proprietorship — Schedule C: Net income: $200,000 SE tax: $200K × 92.35% × 15.3% = $28,260 Deductible half of SE tax: $14,130 Under S-Corp election: Salary: $90,000 FICA on salary (both halves): $90K × 15.3% = $13,770 Distributions: $110,000 FICA on distributions: $0 He circles the comparison. GLEN (CONT'D) Annual employment tax savings: $28,260 minus $13,770 equals $14,490. That's $14,490 per year that stays in Tanya's pocket — or more precisely, that she can invest in her retirement accounts or her business. AGENT DELMORE Over ten years? GLEN $14,490 per year, invested at 7% annual return, compounds to approximately $200,000 over ten years. That's a retirement fund built entirely from tax savings the code explicitly permits. AGENT DELMORE (leaning back) The math isn't the issue, Mr. Nakamura. The issue is whether the salary is reasonable. And based on your documentation... it appears to be.
AGENT DELMORE For my records — what red flags does the IRS look for with S-Corps? GLEN I'll be transparent. There are five things that trigger audits: He counts on his fingers. GLEN (CONT'D) One: zero salary. Some S-Corp owners pay themselves nothing and take everything as distributions. That's indefensible — if you're performing services, you must pay yourself. Two: salary dramatically below market. Paying yourself $30K as a surgeon is going to get flagged. Three: inconsistent year-to-year. If your S-Corp makes $150K one year and you pay yourself $80K, then it makes $400K the next year and you still pay $80K — that raises questions. Four: salary that's a suspiciously round percentage. Exactly 50/50 split or exactly $50K every year regardless of revenue suggests the salary isn't based on market analysis. Five: no documentation. If you can't show HOW you determined the salary, the IRS assumes you picked the lowest number you thought you could get away with. AGENT DELMORE And Ms. Rivers avoids all five? GLEN All five. $90K on $200K revenue, supported by market data, documented in corporate minutes, consistent with her role and experience.
AGENT DELMORE One more question — what does this structure cost to maintain? GLEN Fair question. There are real costs that offset some of the savings. He lists them: GLEN (CONT'D) Formation: LLC filing fee ($150-$300 depending on state) plus S-Corp election on Form 2553 (free to file). Annual costs: — Payroll service: $50-150/month ($600-1,800/year) — S-Corp tax return (Form 1120-S): $800-1,500/year for a CPA — Registered agent: $100-300/year — State franchise tax or annual report: varies ($0-800/year) — Quarterly payroll tax filings: included in payroll service Total annual overhead: approximately $2,000-4,000. He compares: GLEN (CONT'D) Annual overhead: $3,000 (approximately) Annual FICA savings: $14,490 Net benefit: $11,490 per year. The breakeven point is roughly $60,000 in net self-employment income. Below that, the savings don't justify the costs. Above that — and especially above $100K — it's a no-brainer. AGENT DELMORE (nodding) And Ms. Rivers is well above that threshold. GLEN Significantly. This structure makes mathematical sense for her and has since her first year earning over $80K.
Glen leans forward. GLEN Beyond the FICA savings, the S-Corp structure unlocks additional benefits. AGENT DELMORE Such as? GLEN One: an Accountable Plan. The S-Corp can reimburse Tanya for business expenses — home office, internet, phone, travel — tax-free to her and deductible by the corp. No more arguing about Schedule C deductions. Two: retirement contributions. The corp can establish a Solo 401(k) and contribute up to $69,000 per year between employee deferrals and employer profit sharing. The employer match comes from the corp's profits — it's deductible to the corp and not subject to FICA. Three: health insurance. The S-Corp pays Tanya's health insurance premiums. They're deductible by the corp and reported on her W-2 — but not subject to FICA taxes. It's a better arrangement than the self-employed health insurance deduction on Schedule C. AGENT DELMORE These all sound like standard business benefits. GLEN They are. But sole proprietors often miss them because the structure doesn't make them obvious. The S-Corp makes the corp-to-owner relationship clear, and every legitimate business deduction flows naturally from that relationship.
AGENT DELMORE Let's wrap up. How did Ms. Rivers actually make this election? GLEN Form 2553 — Election by a Small Business Corporation. Filed with the IRS. The LLC remains the legal entity, but it's now TAXED as an S-Corporation. For the IRS, it's a tax classification — not a change in legal structure. He shows the form. GLEN (CONT'D) Requirements: one class of stock, no more than 100 shareholders, all shareholders must be US citizens or residents, and it can't be an ineligible corporation type like a bank or insurance company. For a solo freelancer, all of these are automatically satisfied. AGENT DELMORE Filing deadline? GLEN March 15 for an existing entity wanting S-Corp treatment for the current tax year. Or within 75 days of formation for a new entity. Late elections are sometimes accepted under Revenue Procedure 2013-30 if you can show reasonable cause. TANYA (speaking up) We filed ours on time. Glen made sure of that. AGENT DELMORE (closing her folder) I can see that. Ms. Rivers, Mr. Nakamura — your documentation is thorough, your salary is within reasonable range, and your election is properly filed. I don't have further questions on this issue. TANYA (exhaling) Thank you.
EXT. IRS BUILDING — CONTINUOUS Tanya and Glen walk out into the sunlight. Tanya's hands are still shaking slightly. TANYA I thought I was going to owe thousands in back taxes. GLEN You did everything right. The S-Corp election is one of the most well-established tax strategies for self-employed professionals. The IRS doesn't audit them because they're illegal — they audit them to make sure the salary is reasonable. Yours is. He puts on sunglasses. GLEN (CONT'D) IRC Sections 1361 through 1379 — Subchapter S Corporations. Congress created this structure specifically so small business owners could access corporate tax benefits without double taxation. The employment tax savings are a feature, not a bug. The code rewards business owners who structure properly. TANYA Every freelancer I know just files Schedule C and complains about taxes. GLEN And every one of them earning over $80K is leaving $10,000 or more per year on the table. The information is public. The forms are free. The only cost is doing it right. He hands her his card. GLEN (CONT'D) Same time next January for your annual compensation review. We'll adjust the salary based on your revenue and fresh market data. That's how you stay audit-proof. Tanya nods, tucks the card in her bag, and walks toward her car — $14,490 richer every year because she structured properly. FADE OUT. — END —