Incorporation and Self-Employment Tax
A significant difference between the S corp structure and the sole proprietorship and partnership structures occurs with respect to the Self-Employment Tax (SE Tax). Owners of sole proprietorships, partnerships and similarly taxed LLCs pay SE Tax on their share of the business net profit, whereas owners of S corps and similarly taxed LLCs do not.
While owner-employees of an S corp or similarly taxed LLC can avoid the SE Tax, they generally cannot avoid paying employment taxes altogether. Owner-employees of C and S corps, or similarly taxed LLCs who hold executive officer position(s) and manage the day-to-day business of the enterprise, generally need to take a W-2 salary in order to comply with the IRS “reasonable compensation” doctrine for corporate officers. This reasonable compensation requirement tends to mitigate the SE Tax advantages because W-2 salary is subject to Social Security and Medicare tax withholding and also subject to federal and state unemployment taxes.