Your situation is a good example of the ?lack of clarity? in the tax law. First let me say that you should consult with a CPA who can look at your situation in detail and offer some concrete suggestions.

Here are some factors (but not all) considered by the IRS and courts to determine if shareholder-employee compensation is reasonable:
1.Compensation paid for similar positions in other companies. (This appears to be the primary consideration by the courts.)
2.Time spent performing services for the corporation.
3.Compensation paid by the corporation to the officer in prior years.
4.The shareholders background and experience.
5.The corporations financial condition. (A corporation is not expected to pay more shareholder-employee salary than it can afford or even any salary if it has losses.)
6.Comparing compensation to distributions and retained earnings. (Did you take the money out or leave it in the business as capital.)

The Treasury Inspector General for Tax Administration recently issued a report recommending the IRS be more aggressive in pursuing the question of reasonable compensation for corporate shareholder-employees. IRS auditors have now been instructed to look for S-corps that report ?low? shareholder-employee wages where in the past they were only looking for zero wages being reported. Recharacterization of income as wages requires an IRS audit and the IRS currently has a limited number of auditors.

One important small-business rule regarding corporations: Never put real estate into a corporation or equipment that you think you will later want to take out into a corporation.

However, lets look at your possible status and some possible alternatives:

1.As a sole proprietor-
a.) Salary is not an issue as a sole proprietor does not take a salary.
b.) You can stay as a sole proprietor and pay $10,899.60 in social security tax (max @ 6.2%) plus 2.9% medicare tax.
c.) You will pay Federal income taxes in the 10%, 15%, 25%, 28%, and 33% tax brackets.
d.) You could setup a SEP retirement account and save as much as 35.9% (tax in the 33% bracket plus the medicare tax of 2.9%) on the max contribution of $41,000 or a tax savings of maybe $14,719.
e.) Once the Federal and State taxes are paid you have the money with no strings attached.

2. As a C-corp-
a.) You can incorporate as a C-corp, however, as a one man service operation you will be classified as a ?Personal Service Corp? with all net income taxed at the fixed rate of 35%.
b.) The net income is of course after you have taken a ?reasonable salary? and deducted employee benefits that are not deductible as an S-corp. Example of deductible employee benefits would be health insurance for you and your family, medical reimbursement plan for expenses not covered by the insurance (drugs, deductibles, co-pays, medical equip, etc.), group term life insurance up to $50,000 coverage, etc.
c.) Reasonable salary is usually not a big issue in a C-corp as the officers want a reasonable salary so the C-corp gets a deduction on its taxes. Also, its one of the few ways to get the money out of the C-corp and is usually used to ?balance? the tax brackets between the owners personal taxes and the C-corp taxes to obtain the overall lowest tax brackets. As an example: If the owner has no other taxable income and the C-corp net taxable income is say $100,000, then the balance is to give the officer a salary of say $50,000? which he will pay tax at a 15% rate and the C-corp will pay only 15% on the first $50,000 of taxable income. Therefore the whole $100,000 is taxed at only 15% where if no salary was taken the C-corp would pay 15% on the first $50,000, 25% on the next $25,000, and 34% on the last $25,000 of the $100,000.
d.) If you are in a high personal tax bracket (33% or 35%) without considering the C-corp income and the intent is to maximize employee benefits and retirement contributions (knocking that C-corp income way down without it being taxable on your 1040 ) then a C-corp as a Personal Service Corp (35% tax rate) may still be your best option.

3.As a S-corp-
a.) Reasonable salary is a BIG issue as the IRS automatically suspects that you have elected the status just to avoid the self-employment tax. You have to be in a position on audit to prove that you are taking a reasonable salary and have other business reasons (other than SE tax) to justify your low salary. One weak reason might be to accumulate capital for expansion of your business assuming you do not distribute the money to yourself but leave it in the business.
b.) Generally, ?All? S-corp net income is taxable to the shareholders on a per share basis regardless of when the income is paid out. An S-corp does not pay ?dividends? (unless the payment is from retained earnings where the corp was previously a C-corp and paid taxes), rather it pays out the already taxed income as tax-free ?distributions?.
c.) If the S-corp does not distribute the income that you paid tax on, then the income retained in the business (the balance in the AAA account) becomes capital that deserves a reasonable return on profit and income not subject to self-employment earnings. Thus it becomes a factor in the calculation of income available for reasonable salary.
d.) Shareholder-employee benefits paid by the S-corp do not decrease S-corp taxable income, rather they pass thru as possible deductions for 1040 Sch-A as though they were incurred personally. example is health insurance.
e.) Some shareholders pay family members salaries to lower the S-corp?s net income and get money to family members in a lower tax bracket.
..........i.) Proposed Reg ? 1.1366-3 gives the IRS authority to challenge compensation paid to members of the family if the compensation is not reasonable for services performed.
..........ii) .If the child is under age 14 the income tax bracket for the child is the same as the max tax bracket of the parent and therefore is of no advantage.