First, Clear Up the Confusion
"Should I be an LLC or an S-Corp?" is one of the most-asked small-business questions, and it contains a hidden mistake. An LLC is a legal entity — a thing you form with your state. An S-Corp is a tax classification — a status you elect with the IRS. They're not the same category of thing, so they're not really alternatives.
What's actually happening: you form an LLC, and then you choose how that LLC is taxed. By default it's taxed as a sole proprietorship (single-member) or partnership (multi-member). But you can file a form with the IRS to have your LLC taxed as an S-Corp instead. So the real question is: should my LLC elect S-Corp tax treatment? And that's entirely a numbers question.
The Default: How an LLC Is Taxed
A standard LLC is a pass-through entity. The business pays no income tax itself; all net profit flows to your personal return. On that profit you pay both regular income tax and self-employment tax — about 15.3% (covering Social Security and Medicare) on essentially all of your net business profit.
That self-employment tax is the pain point. If your LLC nets $100,000, you're paying roughly 15.3% — about $15,300 — in self-employment tax, on top of income tax. The S-Corp election exists to reduce that number.
How the S-Corp Election Saves Money
When your LLC is taxed as an S-Corp, your business income gets split into two buckets:
- A reasonable salary — which you pay yourself as a W-2 employee. This portion is subject to payroll taxes (the equivalent of self-employment tax).
- Distributions — the remaining profit, paid out to you as an owner. This portion is not subject to self-employment/payroll tax.
That second bucket is the savings. You still pay income tax on everything, but you avoid the ~15.3% self-employment tax on the distribution portion.
The numbers, simplified: Say your business nets $100,000. As a default LLC, you'd pay ~15.3% self-employment tax on the full $100,000 (~$15,300). As an S-Corp, you might pay yourself a reasonable salary of $60,000 (payroll tax applies to that) and take $40,000 as a distribution (no self-employment tax). You've just shielded $40,000 from the ~15.3% tax — roughly $6,000 in savings. That's the core of the S-Corp pitch. Note the savings scale with profit: the more you make above a reasonable salary, the bigger the gap.
The Catch: "Reasonable Salary" Is Not Optional
You can see the temptation — if distributions avoid the tax, why not pay yourself a $10,000 salary and take $90,000 as distributions? Because the IRS requires the salary to be "reasonable" for the work you actually do. Pay yourself an artificially low salary to dodge payroll tax, and you've created one of the most well-known audit red flags there is. The IRS can reclassify your distributions as wages and hit you with back taxes and penalties.
"Reasonable" generally means what you'd have to pay someone else to do your job. There's no single formula, which is exactly why this is an area where a good accountant earns their fee.
The Other Catch: It Costs More to Run
The S-Corp election isn't free money — it adds ongoing overhead:
- Payroll. You now have to actually run payroll to pay yourself a W-2 salary, usually through a payroll service.
- A separate tax return. S-Corps file their own return (Form 1120-S), on top of your personal return.
- An accountant. Between reasonable-salary judgment, payroll, and the extra return, most S-Corp owners need professional help — an ongoing cost.
This is why the S-Corp election is a "profitable enough" decision. The tax savings have to clearly exceed this added cost and hassle.
So When Does It Actually Pay Off?
The election makes sense once your profit is high enough that the self-employment tax savings outweigh the extra payroll and accounting cost. A widely cited rule of thumb is net profit somewhere around $40,000–$80,000+ — below that, the savings often don't justify the overhead; comfortably above it, they usually do. But it's genuinely a "run your specific numbers" decision, ideally with an accountant.
- Stick with default LLC taxation if: your profit is modest, you want maximum simplicity, or you're still early and unprofitable.
- Consider the S-Corp election if: your LLC is consistently profitable well above a reasonable salary for your role, and you're comfortable running payroll and paying for accounting.
One reassuring point: because the S-Corp is just a tax election on top of your LLC, you don't have to decide forever on day one. Many businesses start as default LLCs and make the S-Corp election later, once profit crosses the threshold where it clearly pays.
Frequently Asked Questions
Is an S-Corp better than an LLC?
It's not really an either/or — an S-Corp is a tax election an LLC can make, not a separate type of company. The question is whether your LLC should elect S-Corp taxation. It can save on self-employment tax once you're profitable enough to justify the added cost of payroll and accounting, but for modest profits the default LLC taxation is simpler and often just as good.
How much can an S-Corp election save me?
The savings come from avoiding roughly 15.3% self-employment tax on the 'distribution' portion of your profit — the amount above a reasonable salary. On $40,000 of distributions, that's around $6,000 a year. The more profit you have above a reasonable salary, the larger the savings, which is why it scales with income.
What is a 'reasonable salary' for an S-Corp?
It's roughly what you'd have to pay someone else to do your job. The IRS requires S-Corp owners who work in the business to pay themselves a reasonable W-2 salary before taking distributions. Paying an artificially low salary to dodge payroll tax is a major audit trigger, so this number should be defensible — an area where an accountant's guidance matters.
When should an LLC elect to be taxed as an S-Corp?
Generally once net profit is consistently well above a reasonable salary for your role — a common rule of thumb is somewhere around $40,000–$80,000+ — so the self-employment tax savings clearly outweigh the cost of running payroll, filing a separate return, and hiring an accountant. It's best decided by running your specific numbers with a professional.