S-corp versus sole proprietor: the section 199A effect nobody prices in

Below the threshold an S-corp costs you QBI. Above it, the owner's salary can unlock a deduction a sole proprietor cannot get. Both directions matter, and a FICA only comparison gets both wrong.

ExactSplit · Updated February 28, 2026

The pitch, in one line

The case for an S-corp election is usually made in a sentence. Pay yourself a reasonable salary, take the rest of the profit as distributions, and save the 15.3 percent employment tax on the distributions. The sentence is true. What it leaves out changes the answer, and it changes it in different directions depending on your income.

What an S-corp actually changes

As a sole proprietor, all of your net profit is subject to self-employment tax at 15.3 percent, up to the Social Security wage base of 184,500 dollars for 2026, and 2.9 percent Medicare above that. As an S-corp owner, only your salary is subject to employment tax, split between employer and employee halves that you both pay. Distributions are not subject to employment tax at all.

So on 200,000 dollars of profit with an 80,000 dollar salary, a sole proprietor pays SE tax on about 184,700 dollars of net earnings, while the S-corp owner pays FICA on 80,000. The difference is on the order of 12,000 dollars a year. That is the number the pitch is built on.

Below the threshold, the S-corp costs you QBI

The qualified business income deduction under section 199A is 20 percent of qualified business income, for taxpayers under the threshold of 201,750 dollars single or 403,500 married filing jointly in 2026. The catch is that wages paid to the owner are not qualified business income. They are wages.

As a sole proprietor, your entire net profit is QBI. Elect S-corp status and pay yourself 80,000 dollars, and that 80,000 stops being QBI. Your deduction drops by 20 percent of 80,000, which is 16,000 dollars of deduction, taxed at your marginal rate. At 24 percent that is roughly 3,800 dollars given back.

Run it on 150,000 dollars of net earnings with a 60,000 dollar salary. Employment tax saved is about 12,000 dollars. The QBI deduction falls by 12,000, which at a 22 percent rate is about 2,600 dollars of extra income tax. Then subtract the costs of being an S-corp, which we get to below. The saving is real but it is roughly a third smaller than the FICA only comparison suggests.

Above the threshold, the sign flips

Above the 199A threshold, the deduction is limited to the greater of 50 percent of W-2 wages paid by the business, or 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis of qualified property. For a specified service business the deduction phases out entirely.

A sole proprietor with no employees pays no W-2 wages. Their own draw is not a wage. So above the threshold, the wage limitation cuts their QBI deduction to essentially nothing. The only thing left is the 400 dollar minimum introduced by the OBBBA for taxpayers with at least 1,000 dollars of active QBI.

An S-corp owner's salary is a W-2 wage paid by the business. Fifty percent of a 160,000 dollar salary is 80,000 dollars of wage limitation, which is enough to support a full 20 percent deduction on a substantial amount of QBI. The election that cost QBI below the threshold now creates a deduction that did not exist.

Run it on 400,000 dollars of net earnings with a 160,000 dollar salary, single, not a specified service business. Employment tax saved is about 10,600 dollars, smaller than at lower incomes because the Social Security wage base caps the sole proprietor's SE tax. The QBI effect adds about 44,800 dollars of deduction that the sole proprietor could not claim at all. The 199A effect is four times the size of the FICA effect and points the other way.

The costs that only exist as an S-corp

An S-corp has to run payroll, even for one employee. That means a payroll service, quarterly 941 filings, W-2s, and state unemployment registration. A commodity provider runs somewhere around 600 dollars a year for a single employee.

An S-corp files its own return, Form 1120-S, in addition to your personal 1040. A preparer will charge for it separately, and 1,200 dollars a year is a reasonable planning figure.

Many states charge a franchise tax or minimum entity fee regardless of profit. California's 800 dollar minimum franchise tax is the best known, but Tennessee, Texas above a revenue threshold, and several others have their own. This is the input most likely to flip the answer for a modest business, and it is entirely state specific, so there is no honest national default.

Reasonable compensation, which has no formula

The whole structure depends on the salary being reasonable. The IRS can reclassify distributions as wages if the salary is too low, and it does. The standard is what the corporation would have paid an unrelated person for the same services, based on all the facts and circumstances.

There is no safe harbor percentage. The 60 percent rule of thumb you may have heard is not from the IRS. The IRS fact sheet on the subject, FS-2008-25, and its internal job aid for valuation professionals both make clear that it is a case by case determination. Any tool that fills in a salary number for you is inventing your answer.

Break-even depends on the salary ratio

Because the saving depends on the split between salary and distributions, and the costs are mostly fixed, there is a level of net earnings below which the S-corp loses money and above which it wins. That break-even moves with the salary ratio. A higher salary means less distribution to shelter and a later break-even.

With 600 dollars of payroll, 1,200 of tax prep, and no franchise fee, at a 40 percent salary ratio the break-even is roughly 22,000 dollars of net earnings. At a 60 percent ratio it is roughly 38,000. Add California's 800 dollar fee and the 40 percent break-even moves to about 31,000. These are illustrative. Your numbers depend on your inputs.

How ExactSplit handles it

ExactSplit models both structures on your actual numbers. It computes employment tax under each, subtracts the costs you enter, and models the 199A effect in whichever direction it cuts at your income, reporting it as its own line so you can see whether QBI helped or hurt. It finds the break-even at your own salary ratio by searching for a real sign change rather than assuming one.

The salary field starts blank on purpose. There is no default because there is no defensible default. And every result is flagged for a CPA, because an S-corp election is a structural decision with payroll obligations, a separate return, and an audit standard to defend. The arithmetic is ours. The decision is not.