LLC vs S-Corp: Which One Actually Saves You More

How a default LLC is taxed

A limited liability company is a legal structure, not a tax category. By default the IRS does not tax an LLC as its own thing at all: a single-member LLC is treated as a disregarded entity (its profit and loss land on the owner's Schedule C), and a multi-member LLC is taxed as a partnership. In both cases the business itself pays no federal income tax; the profit "passes through" to the owners and is taxed on their personal returns.

The catch is self-employment tax. Because the owner of a default LLC is not an employee, the government collects Social Security and Medicare through the self-employment tax instead of payroll withholding. That tax runs at 15.3% (12.4% for Social Security up to an annual wage base, plus 2.9% for Medicare with no cap, and an additional 0.9% Medicare surtax above higher-income thresholds). Critically, it applies to all of your net profit from the business, on top of ordinary income tax.

For a founder netting a modest amount, that is simply the cost of being self-employed. But once the profit grows, the self-employment tax on every dollar becomes the single line most owners want to shrink, and that is exactly the door the S-corp election opens. If you want the wider view of how small business income is taxed first, start with our small business tax guide.

What the S-corp election changes

An S-corporation is a tax election, not a different company. An eligible LLC keeps its exact legal form and simply asks the IRS to be taxed under Subchapter S by filing Form 2553. Nothing about your liability protection, ownership, or bank accounts has to change. What changes is how the owner's pay is characterized.

Under the S election, an owner who works in the business becomes an owner-employee, and the company's profit is split into two streams:

• A reasonable salary paid through payroll, which is subject to FICA (Social Security and Medicare, split between the employer and employee shares)
• Distributions of the remaining profit, which are not subject to FICA or self-employment tax

That is the whole engine. It is also why the salary number is not a detail you get to pick freely: the smaller the salary, the larger the FICA-free distribution, which is precisely why the IRS polices the salary side so closely.

The reasonable compensation catch

The S-corp benefit is bounded by a single hard rule: an owner-employee must first pay themselves reasonable compensation for the services they actually perform, before taking distributions. This is where most of the internet gets it wrong.

Set the salary too low and you invite recharacterization: the IRS has long-standing authority, upheld by courts, to reclassify distributions as wages when an owner is undercompensated. The result is back payroll taxes on the reclassified amount, plus penalties and interest running from the original due dates. The savings you thought you captured turn into a bill, often across several years at once.

Because the salary number is where the risk lives, it deserves its own analysis. Our reasonable compensation guide walks through how the figure is actually built, what the leading case law says, and the documentation that stands up when someone asks for it.

The real cost of running an S-corp

The FICA savings do not arrive for free. An S-corp carries recurring compliance costs that a disregarded LLC never had, and honest math has to subtract them before calling the switch a win:

None of these are optional if you want the election to hold up. An S-corp that skips payroll, files late, or takes distributions with no salary is not saving money; it is accumulating exposure. The cost side of the ledger is the reason the election is not automatically right just because it is available.

Where the savings beat the costs

Put the two sides together and the decision becomes an arithmetic problem, not a slogan. The benefit is at most roughly 15.3% of the profit you can legitimately shift from salary into distributions, and less than that once the salary passes the Social Security wage base, where the rate on the shifted dollar falls to 2.9%. The cost is the ongoing payroll, the extra return, the added bookkeeping, and any state-level franchise tax. The election makes sense when the first number comfortably exceeds the second, which is why the honest answer depends on your actual profit rather than a headline percentage.

As a general pattern, many service businesses do not clear the added costs until net profit is well into the tens of thousands of dollars per year, and the case strengthens as profit rises. That is a starting intuition, not a promise. The only reliable way to know is to model your own numbers: your reasonable salary, your expected distributions, your state, and the real cost of the compliance you would be taking on.

The takeaway is not "always elect" or "never elect." It is that the S-corp is a leverage tool that rewards enough profit and enough non-labor income to overcome its own overhead, and that your state can move the line. Run the numbers for your specific situation before you file anything.

Frequently asked questions

Primary sources

1. 1IRS, Limited liability company (LLC)
2. 2IRS, Self-employment tax (Social Security and Medicare taxes)
3. 3IRS, About Form 2553, Election by a Small Business Corporation
4. 4IRS, S corporation compensation and medical insurance issues
5. 5IRS, About Form 1120-S, U.S. Income Tax Return for an S Corporation
6. 6IRS, About Form 941, Employer's Quarterly Federal Tax Return
7. 7California Franchise Tax Board, S corporations (1.5% tax and minimum franchise tax)
8. 8California Franchise Tax Board, Corporations (minimum franchise tax and first-year exception)