S corp vs LLC: the tax guide.
An LLC is a state law entity and an S corporation is a federal tax election, so the comparison is between an LLC taxed by default and an LLC that has elected S corporation treatment. The default pays self-employment tax on all net earnings. The S election splits income into wages and distributions, and only wages carry payroll tax.
What is the difference between an LLC and an S corp?
They are not the same kind of thing, and most confusion in this comparison starts there. A limited liability company is formed under state law and gives you liability protection and a flexible operating agreement. An S corporation is a tax classification granted by the IRS under Subchapter S. A corporation can elect it, and so can an LLC. The IRS sets out the choices at business structures and covers the entity itself at limited liability company (LLC).
Left alone, an LLC has a default federal tax treatment. A single-member LLC is disregarded, and its activity lands on Schedule C of the owner's Form 1040. A multi-member LLC is taxed as a partnership, files Form 1065, and issues a Schedule K-1 to each member. Neither default pays federal income tax at the entity level. Both push the income out to the owners, who pay tax at their own rates.
Electing S corporation status changes the tax return, the payroll obligation and the way money leaves the business. It does not change the legal entity, the state filings, or the liability protection. Your LLC is still an LLC in the eyes of the state after the election.
How does the S corp election actually save tax?
Through self-employment tax, and only through self-employment tax. A default LLC owner pays self-employment tax at 15.3 percent on net earnings from the business: 12.4 percent for Social Security up to the annual wage base, and 2.9 percent for Medicare with no ceiling, plus the Additional Medicare Tax above the applicable threshold. The IRS explains the mechanics at self-employment tax.
Under an S election, the owner-employee takes a reasonable wage through payroll, and that wage carries Social Security and Medicare tax in the normal employment way. Profit distributed beyond the wage is not subject to self-employment tax. That difference is the entire saving. Federal income tax is unaffected: the income still flows through to the owner's return either way.
The word doing the work is reasonable. The IRS treats understated owner compensation as its main S corporation compliance issue, and recharacterizes distributions as wages where the wage is too low for the work performed. Its guidance is at S corporation compensation and medical insurance issues. There is no safe harbor percentage in the code, whatever a template on the internet says. Comparable pay for comparable work, documented, is the standard.
S corp vs LLC: a side by side comparison
| Item | LLC, default treatment | LLC or corporation with S election |
|---|---|---|
| Federal return | Schedule C, or Form 1065 with Schedule K-1 | Form 1120-S with Schedule K-1 |
| Self-employment tax | On all net earnings | On the wage only, via payroll taxes |
| Payroll required | No, unless there are employees | Yes, for any owner who works in the business |
| Owner pay method | Owner draws, no W-2 | W-2 wage plus distributions |
| Ownership limits | None in federal tax law | 100 shareholders, one class of stock, no nonresident alien shareholders |
| Return due date, calendar year | April 15 (Schedule C) or March 15 (Form 1065) | March 15 |
| Loss deductibility | Subject to basis and at-risk rules | Subject to stock and loan basis, at-risk and passive rules |
| Extra annual cost | Minimal | Payroll processing, a second tax return, often state fees |
When is an S corp election worth it?
When the profit left after a reasonable wage is large enough that the Social Security and Medicare saving on it exceeds the running cost of the election. The cost side is real and recurring: a payroll service, quarterly Form 941 filings, W-2 and W-3 production, state unemployment registration in every state where you have an employee, a separate Form 1120-S, and usually a state-level franchise or entity fee.
A worked example, illustrative rather than a real client. A consultant nets 160,000 dollars. As a default LLC, self-employment tax applies to net earnings after the deduction for one half of the tax. With an S election and a documented reasonable wage of 95,000 dollars, payroll taxes apply to the 95,000 and the remaining profit is distributed free of self-employment tax. The saving is 2.9 percent Medicare on the distributed profit plus 12.4 percent Social Security on any part of it that would otherwise have fallen below the wage base, less roughly 2,000 to 4,000 dollars a year of payroll and filing cost. At 60,000 dollars of profit the arithmetic is usually marginal. At 160,000 it usually is not.
Three situations change the answer regardless of profit level. If you have foreign owners, the S election is unavailable, because nonresident aliens cannot hold S corporation stock. If you plan to raise venture capital, investors will want a Delaware C corporation and the S election is a step in the wrong direction. If the business owns appreciating real estate, holding it inside an S corporation creates problems on distribution that a partnership does not have.
What about the qualified business income deduction?
Section 199A allows a deduction of up to 20 percent of qualified business income, and it is available to both structures. The IRS summary is at qualified business income deduction, with the computation on Form 8995.
The interaction with an S election is not obvious. Wages paid to yourself are not qualified business income, so a higher wage reduces the 199A base. For specified service businesses above the income threshold, the deduction phases out entirely, which removes that consideration but also removes the deduction. Above the threshold for non-service businesses, the W-2 wage limitation can make paying wages helpful rather than harmful. The point is that the wage decision affects two taxes at once, in opposite directions, and modeling only the payroll tax gets it wrong.
How and when do you make the S election?
You file Form 2553, signed by every shareholder. The deadline is no more than two months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the preceding tax year. For a calendar year business wanting the election effective January 1, that means filing by mid-March of that year. Late elections can often be rescued under IRS relief procedures where there was reasonable cause, but relief is a process, not a right.
An LLC electing S status does not need Form 8832 as well. Filing Form 2553 on its own is treated as electing corporation classification and S status together. Filing both, in the wrong order, is a reliable way to spend three months on the phone to the IRS.
Once elected, the operational changes start immediately. You need an EIN if you do not already have one, a payroll registration in your state, a documented compensation analysis, and a distinction between the wage and the distribution that your bookkeeping actually respects. Owners who keep taking irregular draws and reconstruct a wage in December are the ones who get recharacterized.
What do people get wrong about this decision?
- Treating the LLC and the S corp as competing entities. They are different layers. The question is which tax classification your LLC should carry.
- Setting the wage from a percentage rule. There is no statutory 60/40 split. Use comparable market pay for the role and document how you got there.
- Ignoring state treatment. Several states impose an entity level tax, a franchise fee or a minimum tax that erodes the federal saving, and a few do not recognize the S election at all.
- Forgetting the second return. Form 1120-S is due March 15 for a calendar year filer, a month before the personal return most owners have in their heads.
- Electing too early. At low profit the payroll and filing cost exceeds the saving, and you have added a permanent administrative burden to a business that has not earned it yet.
One opinion, from running both structures for clients: the S election is oversold to businesses under about 80,000 dollars of profit, where it usually costs more in payroll administration and accounting fees than it returns, and undersold to established service businesses well past that point that have simply never been shown the arithmetic. Ask for the model with your own numbers before anyone files a form.
If you are choosing a structure at formation, our company incorporation service covers the entity choice across five countries, and our accountants for US small businesses page sets out how we run the filing calendar afterwards. Owners already trading should read the US sales tax nexus guide, because a growing service business often crosses an economic nexus threshold in the same year it starts thinking about an S election. Payroll for the new wage is covered by our multi-jurisdiction payroll service, and the PAYE versus Form 941 comparison is useful if you also employ people in the UK. Terms used here are defined in our accounting and tax glossary.
Want the S election modeled on your own numbers?
We run the comparison with your profit, your state, your reasonable compensation benchmark and the full cost of payroll, then tell you whether to elect or wait.
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