LLC vs S Corp

"Should I be an LLC or an S corp?" mixes up two different things. An LLC is a legal structure you form with your state. An S corporation is a tax classification you elect with the IRS. Many small businesses are both: an LLC under state law that is taxed as an S corporation.

The short answer

Form the LLC for liability protection. Then, once the business makes steady profit, ask whether electing S corp tax status would lower your total tax by more than the extra costs it brings. For a new business with uncertain income, the default LLC tax treatment is usually simpler.

How the S corp election works

By default, the IRS taxes a single-member LLC like a sole proprietorship and a multi-member LLC like a partnership (IRS: LLCs). To be taxed as an S corporation instead, the LLC files Form 2553. Per the form instructions, an eligible LLC that files it on time is treated as having elected corporate tax classification too, so a separate Form 8832 isn't needed.

Timing matters. For the election to apply to a tax year, the form is generally due no more than 2 months and 15 days after the start of that year, or at any time during the year before. The IRS offers relief for some late elections.

Not every LLC qualifies. Under the IRS rules for S corporations, the business must be domestic, have no more than 100 shareholders, have only allowable shareholders (individuals, certain trusts and estates, but not partnerships, corporations or nonresident aliens) and have only one class of stock.

Where the savings come from

With default LLC taxation, all of your profit is subject to self-employment tax: 15.3% for Social Security and Medicare, with the Social Security part capped at a yearly earnings limit. That's on top of income tax.

In an S corp, you work for your own company. You pay yourself a salary through payroll, and Social Security and Medicare taxes apply to that salary. Profit you take beyond the salary, as distributions, isn't subject to those taxes. Income tax still applies to all of it: S corporation profit passes through to the owners' personal returns.

A rough example

Say the business makes $80,000 in profit. Under default LLC taxation, self-employment tax on it is about $11,304. As an S corp paying a $50,000 salary, payroll tax on the salary is about $7,650 (employer and employee shares together). The difference, about $3,654, is the most you could save before the extra costs below. This is simplified: it ignores income tax effects, deductions and state taxes.

The reasonable salary rule

You can't pay yourself a token salary and take everything else as distributions. The IRS says an S corporation must pay reasonable compensation to shareholder-employees for the services they provide before taking non-wage distributions. It looks at factors like your training and experience, duties, time spent, and what comparable businesses pay for similar work. If the salary is too low, the IRS can reclassify distributions as wages and charge the payroll taxes, plus penalties and interest.

What an S corp election costs

The state side doesn't change: the business is still an LLC, so it pays the same state filing fee and the same annual report fee or tax as before. The extra costs are on the tax side:

• Payroll. Running payroll for yourself, with tax withholding, quarterly payroll returns, W-2s and state payroll registrations. Most owners pay for a payroll service.
• A separate business return. Form 1120-S is due by the 15th day of the 3rd month after the tax year ends (March 15 for a calendar year), with a Schedule K-1 for each owner.
• Accounting help. Most S corp owners use an accountant for the return and to set the salary.
• State differences. Some states tax S corporations at the company level or treat them differently from the federal rules.

The election tends to pay off when profit is steady and well above a reasonable salary for your role, so the payroll tax saved clearly beats these costs. An accountant can run the numbers with your actual income.

When each makes sense

Keep default LLC taxation if…

• The business is new or profit is small or unpredictable.
• Most of the profit would have to be paid as salary anyway.
• You want the least paperwork.

Look at an S corp election if…

• Profit is consistent and clearly above a reasonable salary for your work.
• You're ready to run payroll and file a separate business return.
• All owners are eligible S corporation shareholders.

Still deciding whether to form an LLC at all? See LLC vs sole proprietorship.