An LLC is a legal entity formed under state law; an S corporation is a federal tax status. They are not alternatives: an LLC can elect to be taxed as an S corporation by filing Form 2553. The election can lower self-employment tax once profit is well above a reasonable salary for your work, but it adds payroll and a separate Form 1120-S return.
“Should I be an LLC or an S corp?” is one of the most common questions small business owners ask, and it rests on a mix-up. An LLC is a type of legal entity you form under state law. An S corporation is a federal tax status. They are not opposites. An LLC can choose to be taxed as an S corporation, and many do. The real questions are what legal structure you want and how you want the business taxed.
This guide explains the difference, how the S election works, when it can save tax and what it costs to run. The LLC vs S corp calculator compares the tax on your own profit figures.
What is an LLC?
A limited liability company is created by filing with a state, usually articles of organization with the secretary of state. Its main legal feature is limited liability: in general, the business’s debts and lawsuits stay with the business rather than reaching the owners’ personal assets. It is also flexible: fewer formalities than a corporation and few restrictions on who can own it.
Federal tax law does not have an “LLC tax” category. The IRS classifies an LLC under default rules unless it elects otherwise:
- One owner: treated as a “disregarded entity.” Profit is reported on the owner’s return, on Schedule C for an individual, like a sole proprietorship.
- Two or more owners: treated as a partnership. The LLC files Form 1065 and gives each owner a Schedule K-1.
- By election: an LLC can choose to be taxed as a C corporation or, if eligible, as an S corporation.
What is an S corporation?
An S corporation is a corporation, or an LLC taxed as one, that has elected under Subchapter S of the Internal Revenue Code to pass its income, losses, deductions and credits through to its shareholders. The business files Form 1120-S but generally pays no federal income tax itself; shareholders report their share on their own returns.
To qualify, according to the IRS, the business must:
- be a domestic corporation or eligible entity,
- have only allowable shareholders: individuals, certain trusts and estates, and not partnerships, corporations or nonresident aliens,
- have no more than 100 shareholders, and
- have only one class of stock.
How do you elect S corporation status?
The election is made on Form 2553, signed by all shareholders. According to the form instructions, it generally must be filed no more than two months and 15 days after the start of the tax year the election is to take effect, or at any time during the preceding tax year. An LLC that files a valid Form 2553 is treated as electing to be classified as a corporation, so it does not need to file Form 8832 separately. The IRS has a relief procedure for late elections when there is reasonable cause.
Where does the tax difference come from?
For a single-owner LLC taxed by default, the whole net profit is subject to self-employment tax, 15.3% on most of it (12.4% Social Security up to the yearly wage base plus 2.9% Medicare), in addition to income tax.
An S corporation splits the owner’s money into two parts:
- Salary paid through payroll, subject to Social Security and Medicare taxes (half paid by the company, half withheld from the owner).
- Distributions of remaining profit, which are subject to income tax but not to Social Security and Medicare taxes.
The saving comes from the payroll tax on the part of profit taken as distributions. Income tax is broadly the same either way.
What is the reasonable compensation rule?
You cannot pay yourself a tiny salary and take everything else as distributions. The IRS requires S corporation shareholder-employees to receive reasonable compensation for the services they provide before taking non-wage distributions. The IRS looks at factors such as your training and experience, duties and time spent, what comparable businesses pay for similar services and the company’s compensation history. If the salary is unreasonably low, the IRS can reclassify distributions as wages and charge the payroll taxes, plus penalties and interest.
A worked comparison
Suppose a consultant’s business earns $100,000 of profit.
- Default LLC: self-employment tax on 92.35% of $100,000 is about $14,130.
- S corporation paying a $60,000 reasonable salary: Social Security and Medicare on $60,000 total about $9,180. The remaining $40,000 is distributed without payroll tax.
The gross payroll tax difference is about $4,950. Against that, add the S corporation’s extra costs: running payroll, quarterly payroll filings, a separate business tax return (Form 1120-S), often higher accounting fees and, in some states, additional franchise or entity taxes. If those costs are $2,000 to $3,000 a year, the net benefit is much smaller. There are also secondary effects: a lower salary can mean lower Social Security credits and can change retirement plan contribution limits and the qualified business income deduction.
The rough lesson: the S election tends to make more sense as profit grows well beyond what a reasonable salary for your work would be. At low profit levels, the overhead can cancel out the savings.
Other differences to weigh
- Ownership flexibility. An LLC taxed as a partnership can split profits in ways that do not match ownership percentages, and it can admit any type of owner. An S corporation must allocate by share ownership and must respect the shareholder limits.
- Health insurance. For more-than-2% S corporation shareholders, health insurance premiums paid by the company are included in wages on the W-2, with specific rules the IRS explains on its S corporation compensation page.
- State treatment. Some states tax LLCs or S corporations differently, and some impose minimum taxes or fees. Check your state before deciding.
- Exit and changes. If you revoke an S election, you generally cannot make it again for five years without IRS consent.
Questions to ask before electing
- Is your expected profit comfortably above a reasonable salary for the work you do?
- Are you prepared to run payroll and keep business and personal funds strictly separate?
- Do all current and planned owners meet the S corporation shareholder rules?
- Have you compared the result after accounting fees and state taxes?
Run both scenarios through the LLC vs S corp calculator with your own salary and cost figures. Either way, owners usually need to plan for income tax during the year, which our guide to quarterly estimated taxes covers.
This article is general information, not legal or tax advice. Entity choices have long-term consequences, so confirm the details with a qualified tax professional.