LLC vs S-Corp

People compare an LLC and an S corporation as if they were two entity types, but they are different kinds of things. An LLC is a legal entity created under state law. An S corporation is a federal tax status that an eligible LLC or corporation can elect. Most owners actually choose between an LLC taxed by default and an LLC that has elected S corporation status.

At a glance

How the S election can save money

A member of a default-taxed LLC pays self-employment tax of 15.3 percent on net earnings up to the Social Security wage base, and 2.9 percent Medicare tax above it. With an S election, the owner who works in the business is treated as an employee, receives a salary that bears payroll tax, and takes the remaining profit as distributions that are not subject to self-employment tax. If the business earns well beyond a reasonable salary, that difference can be meaningful.

The costs and limits

• Reasonable compensation: the IRS expects owners to pay themselves a salary comparable to what similar work would earn. Setting it too low invites scrutiny.
• Payroll and compliance: you must run payroll, file quarterly and annual payroll returns, and file an S corporation return.
• Ownership restrictions: no more than 100 shareholders, one class of stock, and shareholders must be eligible individuals, certain trusts or estates.
• State treatment differs: some states tax S corporations differently, so check yours.

How to elect S status

1. Form the LLC (or corporation) and get an EIN.
2. File Form 2553 with the IRS. The deadline is generally no more than two months and 15 days after the beginning of the tax year in which the election is to take effect.
3. Set up payroll and pay yourself a reasonable salary.
4. File an S corporation return each year and issue Schedule K-1s.

When it makes sense

S status usually pays off when the business is consistently profitable enough that the payroll tax savings exceed the extra compliance cost. Many owners start with a default-taxed LLC and consider the election as profit grows. A CPA can model your numbers.

See C-corp vs S-corp for how S status compares with a regular corporation.

Illustrative numbers

These figures are simplified illustrations, not tax advice, and ignore income tax, deductions, and state rules. Suppose an owner's LLC earns $120,000 in net profit. As a default-taxed LLC, self-employment tax applies to about 92.35 percent of that amount at 15.3 percent, roughly $17,000. If the owner instead elects S status and pays a reasonable salary of $70,000, payroll tax on the salary is about $10,700, and the remaining $50,000 is a distribution without self-employment tax. The difference is roughly $6,000 a year before the added cost of payroll processing and a separate tax return, which can consume a meaningful part of the saving at lower profit levels.

That is why the election is usually worth modeling once profit is steady and comfortably above a reasonable salary, and why a CPA's projection beats a rule of thumb.