S Corp vs LLC: How To Choose The Best Structure To Minimize Taxes

Which business structure is best for your business – an LLC or an S-Corp? This is a critical question for small business owners because your entity will directly impact the amount of taxes you pay.

There are over 20 million registered LLCs in the US, compared to just 5 million S corporations. Yet, the S-Corp designation tends to save business owners the most amount of money in taxes.

Furthermore, LLC owners can easily elect to be taxed as an S-Corporation by filing a simple form with the IRS. But unfortunately, most are unaware of the benefits of this entity status.

To help you, this post looks closely at the differences between an LLC vs S-corp. It compares LLC tax benefits against S-Corp tax benefits. And finally, it will help you determine which option may be best for your unique business.

What Is an S-Corp?

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An S-corporation is a special tax status granted by the IRS. It is not a legal business structure like an LLC. However, your business must first be organized as an LLC or a C-Corporation before you can elect S-corp tax status with the IRS. 

Therefore, when you compare an LLC vs. S-corp, you are essentially comparing an LLC taxed as an S-corp against an LLC taxed as a disregard entity.

Disregarded entities include sole proprietors and partnerships. If your LLC is owned by one individual, then you are taxed as a sole proprietor by default. If your LLC is owned by multiple individuals, then you are taxed as a partnership by default.

Therefore, most LLCs as disregarded entities by default. In other words, the IRS sees you and your business as the same entity. There is no separation. All of your business income flows to you personally, and you pay tax on all of that income. 

For example, with an LLC, you normally pay yourself with distributions. You don’t have to put yourself on payroll.

In contrast, with an S-corp, owners who provide services to the business must be put on payroll and paid as an employee. Additionally, their payroll salary is subject to payroll taxes.

Though, these payroll taxes are typically lower than the 15.3% self-employment tax that disregarded entities are subject to. The following section explains this in detail.

S-Corp Tax Benefits

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The primary benefit of electing S-Corp status is that it can reduce your self-employment tax. Entities that are not taxed as a corporation must pay a 15.3% self-employment tax on up to $168,600 in income as of 2024.

In addition, those entities may pay 2.90% – 3.8% in medicare tax on all income earned beyond $168,600, indefinitely.

S-Corporations are not subject to these taxes at the entity level. Instead, these taxes are only assessed at the employee-level and are limited to employee wages – not all of the business income.

The next section illustrates this concept more.

How an S-Corp Can Reduce Self-Employment Taxes

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Remember, as an S-corp, you do not pay self-employment tax on all of your business profits. The example below illustrates how this can reduce your tax liability.

Example: If you earn $150,000 in business income, you will pay about $23,000 in self-employment taxes.

But if you are an S-Corp, you would pay $0.00 in self-employment tax on your business income. Though, you would pay some payroll tax on your employee wages.

In order to fully understand this concept, you must understand the purpose of these taxes to begin with.

The purpose of self-employment tax is to fund Social Security and Medicare, and the 15.3% self-employment tax consists of a 12.4% tax to cover Social Security and a 2.9% tax for Medicare. 

In a traditional employer-employee relationship, the employee pays 7.65% of their income in Social Security and Medicare taxes, and the employer pays a matching amount. Together, these two payments make up 15.3%.

When you own a normal LLC, you are considered to be “self-employed,” and thus, you pay both the employee’s and the employer’s portion of the tax.

In contrast, when you elect to be taxed as an S-Corp, you are not considered to be “self-employed,” and thus, you don’t have to pay self-employment tax. Instead, the S-Corp pays you a salary for the services you provide as an employee of the S-Corp.

Then, you, as the employee, pay the 7.65% Medicare/Social Security tax on your wages, and the S-corp, as your employer, matches the 7.65% tax.

Together, these taxes equal 15.3%, which is equal to the self-employment tax rate. However, as an S-Corp, this rate is only applied to employee wages as opposed to 100% of your business income. The net difference is where you realize tax savings.

The example below illustrates this in detail.

Example of S-Corp vs. LLC Taxation

Example: As indicated earlier, if you earn $150,000 in income and you are not a corporation, you will pay about $23,000 in self-employment tax.

Now, let’s see what happens if you elect to be taxed as an S-corp and you pay yourself a $60,000 salary. 

Your $60,000 salary will be subject to a total 15.3% payroll tax, which includes social security and medicare tax. This is the only amount of portion of earned income that is subject to employment tax.

The remaining $90,000 in profits will not be subject to self-employment tax. Therefore, in this example, you would save $14,000 in self-employment tax.

As business profits increase in any business, the S-Corp status becomes more valuable. Some businesses save hundreds of thousands of dollars in taxes by simply choosing to be taxed as an S-Corporation.

However, there are some drawbacks associated with this tax status that every business owner should be aware of. The following section addresses the disadvantages of an S-Corp.

Drawbacks of S-Corp

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The main drawbacks of an S-corp are the additional costs, time, and tax compliance issues. Let’s explore this in detail.

Extra Costs

Running an S-Corps will cost you a bit more money than a sole prop or a partnership. As an S-Corp, you will have to pay for the following:

• An S-corp tax filing — This is typically more expensive than a non-corporate return

• Payroll software subscription — This may cost a few hundred dollars per year

• Payroll taxes — In addition to self-employment tax, you may need to pay other local taxes and unemployment insurance

• State franchise taxes — Depending on your state, they may apply a franchise tax to your S-corp

Also, you should keep in mind that your time is also an expense. The time you spend setting up your S-corp, running payroll, or making sure that you are compliant, could be spent on growing your business. Before you make this election, make sure the tax savings are worth the extra time and money, and work with a CPA firm to simplify or automate the process for you.

Additional Rules

The second major drawback of S-corporations is the additional rules. S-corps are subject to more stringent rules than LLCs. If you elect to be taxed as an S-corp, you will need to deal with the following:

• Paying yourself a “reasonable” salary — realize the IRS can challenge the concept of reasonable

• Setting up payroll, which includes making tax deposits and filing payroll tax returns

• Filing a standalone S-corp tax return in addition to your personal tax return

• Identifying each shareholder’s basis on the S-corp return

• Holding annual board meetings with other shareholders, if applicable

• Ensuring you never have more than 100 shareholders

• Keeping minutes at the board meetings

If this list stresses you out, this may not be the best option for you. Be aware, however, that these expectations sound a lot more daunting than they are, and a CPA can help you deal with most of these issues.

Limits on Certain Tax Deductions

The third major drawback of an S-corp is that it can limit other deductions you may have. Since you are required to take a salary as an S-corp, any deduction based on your salary may be limited if your salary is less than your business profits, which is normally the case.

This is particularly true in relation to retirement contribution deductions. For example, a SEP IRA is a self-employed retirement plan that allows you to contribute up to 25% of your income and receive a tax deduction.

For example, if your non-S-corp business earned $150,000 in income, then hypothetically, you could contribute $37,500 as an LLC. This is 25% of $150,000.

However, if you are an S-Corp and your salary is $60,000, then you would only be able to contribute $15,000. To put it another way, you’ve lost a $22,500 deduction and reduced the amount you could contribute to your retirement plan.

There are also limitations on hiring your kids. With a normal LLC, you can hire your minor children as employees without paying any Social Security and Medicare taxes. But as an S-corporation, if you hire your kids as employees, you would have to pay these types of taxes.

These tend to be the two most common examples, but there are other issues. To ensure you’re making the right decision, you cannot just consider the potential savings on self-employment taxes. Instead, you must consider every aspect of your unique business situation.

To learn more, read the 15 Major Disadvantages of S Corps.

Now let’s talk about the alternative, LLCs.

Misconceptions of LLC Tax Benefits 

There are a lot of misconceptions about LLCs, and they often revolve around taxes. Many people think that LLCs are what millionaires and entrepreneurs use to lower their tax liabilities, but that isn’t the case.

An LLC is not a tax loophole. In fact, LLCs have nothing to do with your taxes, in general. LLCs are legal entities that protect you from personal liability in the event of a lawsuit.

For example, if someone sues your LLC for damages, the lawsuit should generally only apply to your business, not to you personally. Similarly, if an LLC defaults on a loan, the lender cannot go after the business owner personally unless they personally guaranteed the loan.

LLC Tax Benefits

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The main tax benefits of LLCs are related to its ability to:

• Receive pass-through taxation treatment

• Maximize tax deductions

• Take QBI tax deductions

• Elect S-Corp status

• Be set up easily

Because an LLC is a legal entity, it enjoys the same tax benefits of Sole Proprietors and Partnerships, with the exception of electing S-Corp status.

Keep reading to learn more about each tax benefit.

Tax Benefit #1: Pass-through taxation

Pass-through taxation means that all of your business profits are subject to taxation once on your individual return. 

The alternative is double taxation. 

Double-taxation means that, technically, you are taxed twice – first of all, your business is taxed on all of its profits. And secondly, when you are paid, you are also taxed on income that you take out of your business.

With that being said, a major tax benefit of LLCs is that it is only taxed once with pass-through taxation. Here’s an example:

Let’s say you make $100,000 as an LLC. If your tax rate is 25%, then you would only pay $25,000.00 in taxes as an LLC.

In comparison, imagine you’re a C-corporation. If you make $100,000 as a C-corporation, your business would be taxed on that income first. If the corporate tax rate is 21%, then you would pay $21,000 in taxes. But then, on top of that, you have to pay taxes on what you pay yourself from your corporation. Let’s say you pay yourself $50,000.00 in W-2 wages, and this puts you in a 25% tax bracket. This would mean you would have to pay an additional $12,500.00 in taxes.

So, in summary, as a C Corporation, you would pay $33,500 in taxes, whereas, with an LLC, you would only pay $25,000 in taxes.

Note that this is an oversimplified example and there are additional things to consider, like the self-employment tax, for example. However, in general, this is an example of how someone could view an LLC as a tax benefit.

Tax Benefit #2: Tax Write-Offs

Tax write-offs are another significant benefit of becoming an LLC. As a self-employed individual, you can write off eligible business expenses like home office expenses, business travel, and other necessary and ordinary expenses for your business. You can also take an above-the-line deduction for health insurance premiums.

To ensure you don’t miss any write-offs, you should consider separating your personal and business finances. For example, if you have a business bank account, you can sync your financial information with a bookkeeping platform like QuickBooks. Then, you can categorize all of your business transactions so you can easily start deducting eligible expenses from your tax return.

Tax Benefit #3: Pass-through Tax Deductions

LLCs that are taxed as pass-through entities (rather than S-corps) can also claim a 20% pass-through tax deduction.

Part of the Tax Cuts and Jobs Act (TCJA), this rule allows qualifying pass-through owners to deduct up to 20% of their business income from their taxable income. For example, if you were reporting $100,000 in business income on your tax return, this deduction would reduce your taxable income to $80,000. This could save you thousands of dollars on your business tax return.

There are a few additional rules and regulations that may disqualify you from receiving this tax deduction. However, if you are eligible for it, it could turn into some good tax savings.

Tax Benefit #4: S-Corporation Election

Another tax benefit of LLCs is that you can elect to be taxed as an S-corporation. When you make this election, you reap all of the legal benefits of being an LLC along with the tax benefits of being an S-corp. However, you must consider the drawbacks of S-corps.

Tax Benefit #5: LLCs are Easy to Set-Up

One of the best things about LLCs is that it is fairly easy to set up, which ultimately makes filing your taxes much easier and less stressful than other entity types. 

LLCs have fewer compliance requirements than other tax entities. With an LLC, you don’t have to worry about divvying up stuff like common stock and preferred stock. And, there is less record-keeping required for setting up your LLC.

When to Switch Your LLC to an S-Corp

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The best time to switch your LLC to an S-Corp is when the benefits of the S-Corp outweigh the drawbacks.

Or in other words, you should become an S-corp when it will save you more money than it costs you in money, time, and other efforts. The more money your business earns that is subject to self-employment taxes, the more likely you are to benefit from switching to an S-Corp versus staying in an LLC.

The general rule of thumb that a lot of people subscribe to, is to elect S-corp status once your business income exceeds $40,000 per year. At this income level, you should be able to shave off about $6,000 in self-employment taxes, but you will incur about $2,000 to $3,000 in payroll taxes plus the costs for the additional tax returns.

That’s getting close to the breakeven point for most businesses. Again, however, you need to consider if you’re missing any deductions that could lower your overall tax burden and make an S-corp unnecessary. Because of that, the general rule of thumb may not be right for you, and in fact, a lot of CPAs don’t recommend an S-corp until you get to $75,000 to $100,000 per year.

But it’s not a decision you can just make on profits alone. You have to consider all of the unique factors related to your business. The decision could be even more complex if you already have W-2 income, multiple business partners, or other unique circumstances going on.

That’s why we always recommend getting a tax professional involved when making decisions like this. These decisions can result in thousands of dollars in tax savings or thousands of headaches.