Leveling Up Your Side Hustle: When to Elect Subchapter S Taxation

You started your business as a side hustle. You had a few clients, a few invoices,  a simple LLC to keep things organized, and a dream. But now it’s growing. You’re earning real money, paying yourself regularly, and starting to wonder: Is it time to level up my tax strategy?

That’s where Subchapter S taxation, often called the “S-Corp election,” enters the picture.

What Does It Mean to “Elect S-Corporation Status”?

By default, the IRS treats your LLC as a disregarded entity (if you’re the only owner) or a partnership (if you have business partners). In both cases, all of your net profit “passes through” to your personal return — and you pay self-employment tax (15.3%) on every dollar of it.

When you elect to be taxed under Subchapter S of the Internal Revenue Code (by filing IRS Form 2553), your LLC remains an LLC under state law — but for tax purposes, it’s treated like an S-Corporation.

This is a highly effective cost saving maneuver if your LLC is generating a significant amount of income because you can split your income between a reasonable salary, which is subject to payroll taxes, and distributions of profit, which are not subject to payroll taxes.

Why This Can Save You Money

Let’s look at an example:

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Your business nets $100,000 after expenses.

• As a standard LLC, you pay 15.3% self-employment tax on the entire $100,000 → roughly $15,300.

• As an S-Corp, you pay yourself a “reasonable salary," something like $60,000, which is subject to payroll tax. The remaining $40,000 is distributed as profit and avoids that 15.3% SE tax.

That alone can save around $6,000 per year, sometimes more.

This structure is completely legal and explicitly recognized by the IRS — as long as the salary you pay yourself is “reasonable” for the work you perform.

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Is There Anything "Reasonable" About Taxes?

One of the most common pitfalls business owners run into here is getting too excited about avoiding payroll taxes to get their distribution. As it always is in a legal context, "reasonable" is here a term of art, and it's imperative that your idea of reasonable is lined up with the IRS's. It would be too easy for them to give a formula, but they have defined key factors including: your training/experience, duties, time devoted, comparable market pay, and whether the business’s income comes mainly from your services vs. other employees or capital/equipment. See this guidance and this fact sheet for more details.

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How to Set (and Defend) Your Salary

An Owner-operator checklist you can keep on file (this is what examiners look for):

• A brief memo of your duties, hours, and the share of revenue tied to your personal services vs. staff/capital. (IRS says start by identifying what the shareholder did and the sources of gross receipts.) IRS
• Comparable pay data  for similar roles in your market. If you wear multiple hats, build a blended salary (e.g., 40% practitioner, 30% business-development, 30% admin/management). (This mirrors the job aid’s approaches.) The Bureau of Labor Statistics keeps these numbers available to the public and is an excellent reference.
• A note confirming that wages are paid before distributions.
• Annual review: revisit comps and your time allocation; adjust salary if your duties or profits change meaningfully. (Courts have recharacterized distributions when static low salaries didn’t match growing businesses.) journalofaccountancy.com

Rule of thumb (not law): if your firm’s gross receipts primarily reflect your services (common in solo practices), your salary should be close to market pay for a professional with your skills and billable load. Distributions then reflect profit on top of wages—not a substitute for wages. (That’s exactly what two landmark cases, Watson and McAlary, drove home.)

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Don’t Forget the 20% QBI Deduction

One of the most valuable perks for small-business owners under the 2017 Tax Cuts and Jobs Act (TCJA) is the Qualified Business Income (QBI) deduction under Internal Revenue Code §199A.

Here’s how it works:

• If your business is a pass-through entity (sole proprietorship, partnership, or S-Corp), you may be able to deduct up to 20% of your qualified business income from your taxable income.
• This deduction applies in addition to your regular business expenses it’s a direct reduction to taxable income, not just an expense write-off.
• The deduction phases out at higher income levels (roughly starting around $191,950 for single filers and $383,900 for joint filers in 2025), especially for certain “specified service trades or businesses” like law, accounting, and consulting.

How It Interacts with S-Corp Status

• Whether you’re taxed as an LLC or an S-Corp, your profits are generally still considered qualified business income for the deduction.
• However, your W-2 salary from your S-Corp does not count toward QBI, only the profit distributions do.
• In practice, the salary/distribution split not only reduces self-employment tax, but also helps you optimize your QBI deduction if managed properly.

For many growing businesses, combining S-Corp tax treatment with the QBI deduction produces one of the most tax-efficient setups available under current federal law.

When It Makes Sense to Elect S-Corp Status

While the S-election can be a great tool, it’s not right for everyone. You’ll want to consider:

Your Profit Level

If your net income is consistently over $50,000–$70,000, the savings often outweigh the added cost of payroll services and bookkeeping. If profits are lower or unpredictable, the default LLC treatment may still be better.

Your Role in the Business

S-Corp benefits apply only if you’re actively working in your business. Passive investors won’t see the same savings because distributions aren’t treated the same way.

Your Willingness to Handle Extra Admin

You’ll need to run payroll, file quarterly tax reports, and possibly pay yourself through W-2 wages. For many growing entrepreneurs, that’s a small trade-off for the tax efficiency — but it’s still a commitment.

How to Make the Election

If you and your CPA decide it’s the right time:

1. File Form 2553 with the IRS.
2. Set up a formal payroll system for yourself.
3. Continue filing your annual LLC reports with the Texas Secretary of State as usual.

From there, you’ll file your business taxes using Form 1120-S each year and receive a Schedule K-1 showing your share of the company’s profits.

Leveling Up, the Smart Way

Electing Subchapter S status isn’t about gaming the system — it’s about understanding the rules and using them strategically as your business grows.

If your side hustle has become a true business and you’re starting to see consistent profits, it may be time to explore the S-Corp option. It’s one of the simplest, most effective ways to keep more of what you earn while staying fully compliant with tax law.

Find a form you can download below to determine what a reasonable salary is, and to make a paper trail to protect yourself if the tax man comes knocking.

Need help deciding whether it’s time to make the switch?
At the Law Office of Seth J. Howell, we help small business owners across Texas evaluate their structure, plan for growth, and stay tax-efficient without adding unnecessary complexity.

Schedule a consultation to find out whether Subchapter S taxation and the QBI deduction are right for your business.

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