S-Corp Election for Freelancers: When It Saves Money (And When It Doesn't)

S-Corp election is the most powerful tax-saving strategy for high-earning freelancers—but it's not for everyone.

At the right income level, S-Corp can save $5,000-15,000+ annually in self-employment taxes. At the wrong income level, the added complexity and costs make it a net negative.

This guide helps you determine if S-Corp is right for you.

How S-Corp Saves Taxes

As a sole proprietor or single-member LLC, all net profit is subject to self-employment (SE) tax of 15.3% (Social Security + Medicare).

With S-Corp election, you split income into two categories:

Salary: Subject to payroll taxes (equivalent to SE tax)

Distributions: NOT subject to SE tax

Example at $150,000 net income:

The key: Only the salary portion faces payroll taxes. The remaining $80,000 in distributions is taxed as ordinary income but avoids the 15.3% SE tax.

The "Reasonable Compensation" Requirement

The IRS requires S-Corp owner-employees to pay themselves a "reasonable salary" before taking distributions. This prevents the obvious strategy of paying $0 salary and taking everything as distributions.

Factors determining reasonable salary:

• Training and experience
• Duties and responsibilities
• Time devoted to the business
• Comparable pay in your industry
• Company size and financial performance

Safe approach: Pay yourself what you'd have to pay someone else to do your job. Research market rates for your role.

Red flag: Salaries significantly below market (the IRS pays attention to this).

S-Corp Costs and Complexity

S-Corp isn't free. Before celebrating tax savings, account for:

Required costs:

• Payroll service: $300-600/year
• S-Corp tax return (Form 1120-S): $500-1,000+ CPA fees
• State filing fees: $0-800/year depending on state
• Registered agent (if required): $100-300/year

Increased complexity:

• Must run payroll (at least quarterly)
• Separate tax return filing
• More bookkeeping requirements
• State compliance (some states have S-Corp taxes)

Annual cost estimate: $1,000-2,500/year in added expenses

The Break-Even Analysis

S-Corp makes sense when tax savings exceed added costs.

Simplified formula:

Tax savings = (Net income - Salary) × 15.3%

Net benefit = Tax savings - S-Corp costs

General rule: S-Corp typically becomes beneficial around $80,000-100,000 in consistent net income.

When S-Corp Makes Sense

Good candidates:

• Net income consistently above $80,000
• Stable, predictable income
• Willing to run payroll
• Willing to file additional tax returns
• Long-term business (not a short-term project)

Ideal candidates:

• Net income above $150,000
• Established business with track record
• Already working with a CPA
• Want to maximize tax savings

When S-Corp Doesn't Make Sense

Avoid S-Corp if:

• Net income below $60,000 (costs exceed savings)
• Income highly variable (hard to set consistent salary)
• You value simplicity over optimization
• Planning to sell business soon
• Business is new/unproven

Other considerations:

• Some states have extra S-Corp taxes (California: 1.5% of net income, minimum $800)
• Retirement contribution calculations differ
• Health insurance deduction rules differ

How to Elect S-Corp Status

Option 1: Form New S-Corp

1. Form an LLC in your state

2. File Form 2553 with IRS within 75 days of formation

3. Wait for IRS approval letter

Option 2: Convert Existing LLC

1. File Form 2553 with IRS

2. Deadline: By March 15 for current year (or within 75 days of year start)

3. Late election relief available in some cases

Option 3: Direct S-Corp Formation

1. Form a corporation in your state

2. File Form 2553 with IRS

3. Ensure single class of stock (S-Corp requirement)

Most common path: Form LLC, then elect S-Corp tax treatment. Provides liability protection with tax flexibility.

The Salary Decision

Setting your salary is the most critical decision. Too low invites IRS scrutiny. Too high erases tax savings.

Research methods:

• BLS Occupational Employment Statistics
• Industry salary surveys
• Job postings for similar roles
• What you'd pay a replacement

Documentation:

• Keep records of how you determined salary
• Document time spent on business activities
• Maintain job description

Safe approach: Pay yourself 50-60% of net income as salary initially, then adjust based on research.

State-Specific Considerations

Some states make S-Corp less attractive:

California: 1.5% tax on S-Corp net income (minimum $800)

New York City: S-Corp must file separate NYC return

Texas: No income tax, but franchise tax may apply

No state income tax: Florida, Texas, Nevada, etc.—S-Corp may be more attractive (no state-level complications)

Research your state's S-Corp rules before electing.

S-Corp and Retirement Contributions

S-Corp changes retirement contribution calculations:

Solo 401(k):

• Employee deferral: From W-2 salary (up to $23,500)
• Employer contribution: 25% of W-2 salary

Example: $75,000 W-2 salary

• Employee deferral: $23,500
• Employer contribution: $18,750 (25% of $75K)
• Total: $42,250

Compare to sole prop at $150,000:

• Employee deferral: $23,500
• Employer contribution: $34,632 (25% of adjusted SE income)
• Total: $58,132

Tradeoff: S-Corp may reduce maximum retirement contribution, but the SE tax savings often exceed this limitation.

Health Insurance Considerations

S-Corp health insurance rules differ from sole proprietor:

Sole proprietor: Deduct premiums above-the-line on Form 1040

S-Corp: Must include premiums in W-2 wages, then deduct above-the-line. Slightly more complex but same result.

Setup: S-Corp pays premiums (or reimburses 2%+ shareholder), reports on W-2, shareholder deducts on personal return.

Exit Considerations

Planning to sell your business or bring in partners?

S-Corp limitations:

• Only one class of stock allowed
• Maximum 100 shareholders
• Only individuals/certain trusts can be shareholders
• No non-resident alien shareholders

If you might:

• Raise venture capital: S-Corp won't work
• Sell to PE firm: May need to convert
• Add partners with different rights: S-Corp limited

For most solo freelancers, these limitations don't matter.

Frequently Asked Questions

Can I revoke S-Corp election if it doesn't work out?

Yes, but there's a 5-year waiting period before you can re-elect. Make sure S-Corp is right before electing.

Do I need an LLC to elect S-Corp?

No. You can form a corporation directly and elect S-Corp status. However, LLC + S-Corp election is the most common path for freelancers.

What if my income varies significantly year to year?

S-Corp is harder with variable income because salary should be consistent. You might overpay some years. Consider if the average savings justify the commitment.

Can I do my own S-Corp payroll and tax returns?

Technically yes, but mistakes are costly. Most S-Corp owners use payroll services ($30-50/month) and CPAs for the 1120-S return.

Make the Right Choice

S-Corp election can save thousands—or cost money if implemented wrong. Model the math for your specific situation before making the decision.

AlphaTax helps you project income and estimate potential S-Corp savings based on your actual numbers.

Model Your Tax Scenarios →