LLC vs. S Corp: Which Is Right for Your Small Business?

LLC vs S corp guide for small business owners by Robert Allen Bautista, Kansas City tax preparer"Should I be an LLC or an S corp?" is one of the most common questions small business owners ask, and it is a little bit of a trick question. An LLC is a legal structure created under state law. An S corporation is a tax election made with the IRS. Many small businesses are both: an LLC that elects to be taxed as an S corporation. Here is how to think about it.

1. What an LLC does

A limited liability company separates your business from you personally, which can protect your personal assets from business debts and lawsuits if you keep the business truly separate. For federal taxes, a single-member LLC is ignored by default: profit goes on Schedule C of your personal return, and you pay self-employment tax (about 15.3 percent) on nearly all of it.

2. What the S corporation election does

When an LLC (or corporation) elects S status by filing Form 2553, you become an employee of your own company. You pay yourself a reasonable salary through payroll, which is subject to payroll taxes. Profit above that salary can be paid out as distributions, which are not subject to self-employment or payroll tax. That difference is where the savings come from.

3. When the S corp math works

The election usually starts to make sense once profit is comfortably above what a reasonable salary for your work would be, often when net profit reaches roughly $50,000 to $80,000 or more, depending on your industry and state. Below that, the savings are small and can be wiped out by the extra costs.

4. The costs people forget

  • Running payroll (software or a provider), with quarterly payroll filings and W-2s
  • A separate business tax return (Form 1120-S), which usually costs more to prepare
  • State fees or taxes; some states treat S corporations differently
  • More bookkeeping discipline: no mixing personal expenses, and accountable plans for reimbursements

5. "Reasonable salary" is not optional

The IRS expects owner-employees to pay themselves a salary comparable to what they would pay someone else to do the job. Paying yourself $0 or a token salary and taking everything as distributions is one of the most common audit triggers for S corporations, and it can lead to back payroll taxes and penalties.

6. A simple example

A consultant with $120,000 of profit who elects S status and pays a $65,000 reasonable salary pays payroll tax on the $65,000 instead of self-employment tax on nearly all $120,000. The difference can be several thousand dollars a year, before subtracting payroll and return-preparation costs. The exact answer depends on the numbers, which is why it is worth running them before electing.

7. Timing

To take effect for a calendar year, the S election generally must be filed within the first two and a half months of that year (by about March 15), or within two and a half months of a new entity's start. Late-election relief exists, but it is easier to plan ahead.

Bottom line

Form the LLC for liability protection. Consider the S corporation election once your profit clearly supports a reasonable salary plus the extra costs. Run the numbers with a tax professional before you file Form 2553.

This article is general information, not tax advice for your specific situation.

More from Robert Allen Bautista

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