LLC vs S Corp: How Each Is Taxed and When the Switch Makes Sense

Your business is finally making real money, and someone at a networking event tells you that you’re “throwing away thousands” by staying a plain LLC. Switch to an S corp, they say, and you’ll save on taxes. Are they right?

Sometimes. The honest answer depends on how much profit you make, how much you’d need to pay yourself as salary, what your state charges, and whether you’re willing to run payroll. This guide explains how each option is taxed, where the savings actually come from, and the point at which an S election is worth a serious conversation with a CPA.

This is general information, not legal or tax advice. Tax rules change, and your situation may differ.

The key difference: one is a legal entity, one is a tax choice

The most common confusion is treating these as 2 alternatives of the same kind. They aren’t.

• An LLC (limited liability company) is a legal entity you form with your state. It separates your business from you personally, which can help shield personal assets from business debts and lawsuits.
• An S corporation is a federal tax status, named after Subchapter S of the Internal Revenue Code. A corporation or an eligible LLC chooses it by filing Form 2553 with the IRS.

So the real question usually isn’t “LLC or S corp?” It’s “Should my LLC stay with its default tax treatment, or elect to be taxed as an S corp?” Your legal protection stays the same either way. Only the tax treatment changes.

How an LLC is taxed by default

The IRS doesn’t have a separate tax category for LLCs. Instead, it applies a default:

• Single-member LLC: treated as a “disregarded entity.” You report profit on Schedule C of your personal return, just like a sole proprietor.
• Multi-member LLC: treated as a partnership. The LLC files Form 1065, and each member gets a Schedule K-1 showing their share of profit.

In both cases, the profit “passes through” to the owners, who pay income tax at their personal rates. The big extra cost is self-employment tax.

What self-employment tax is

Self-employment tax is how business owners pay into Social Security and Medicare. Employees split these taxes with their employer, but when you’re self-employed you pay both halves. For 2026, the rate is:

The tax is calculated on 92.35% of your net self-employment earnings, and you can deduct half of it when figuring your income tax. Even so, on a $100,000 profit, self-employment tax comes to roughly $14,100. That number is what makes the S corp conversation start.

How an S corp is taxed

An S corp is also a pass-through. The business generally pays no federal income tax itself. It files Form 1120-S, and owners report their share of profit on their personal returns through a Schedule K-1.

The difference is how the owner who works in the business gets paid. In an S corp, you become an employee of your own company and split your money into 2 buckets:

1. Salary (W-2 wages). Subject to Social Security and Medicare payroll taxes (the employee and employer halves add up to the same 15.3%), plus income tax withholding.
2. Distributions. The remaining profit, paid out to you as an owner. Distributions are subject to income tax but not to Social Security or Medicare tax.

That’s the whole savings mechanism. Profit that comes out as a distribution avoids the 15.3%.

S corp eligibility rules

According to the IRS, to be an S corp a business must:

• Be a domestic corporation (or an LLC eligible to elect corporate tax treatment)
• Have no more than 100 shareholders
• Have only 1 class of stock
• Have only allowable shareholders: individuals, certain trusts and estates (not partnerships, corporations or nonresident aliens)

The single-class rule matters for startups. If you plan to raise venture money with preferred shares, an S corp usually won’t fit. Founders raising early money often use a C corporation and instruments like a SAFE note instead.

The reasonable salary rule

You can’t avoid payroll tax by paying yourself $1 in salary and taking everything else as distributions. The IRS says an S corp must pay reasonable compensation to a shareholder-employee for the services they provide before taking non-wage distributions.

There’s no fixed percentage or formula. The IRS and the courts look at the facts, including:

• What you actually do for the business and how many hours you work
• What comparable businesses pay for similar work
• Your training and experience
• Where the company’s revenue comes from. Income generated by your own personal services points toward wages, while income from other employees or from equipment and capital can support distributions

The IRS also warns against taking compensation as distributions, personal expenses paid by the company, or loans instead of wages. If the IRS reclassifies distributions as wages, you can owe back payroll taxes, penalties and interest.

Key takeaway: The S corp savings come only from the gap between your total profit and a reasonable salary. If your work is the business and a fair salary would eat most of the profit, the savings shrink to very little.

A worked example

Here’s a simplified illustration for a single owner. It ignores state taxes, retirement contributions and the deduction for half of self-employment tax, so treat it as a way to see the mechanics, not a forecast.

That $4,950 isn’t pure savings. You’ll pay for things a default LLC doesn’t need: a payroll service, a separate business tax return (Form 1120-S) that usually costs more to prepare, state unemployment insurance, and in some states an entity-level tax. California, for example, charges S corporations 1.5% of net income with an $800 minimum franchise tax.

There are other trade-offs:

• Lower Social Security earnings record. Paying less payroll tax can mean a smaller recorded earnings history for future Social Security benefits.
• QBI interaction. The 20% qualified business income deduction, which the 2025 tax law made permanent, doesn’t apply to W-2 wages you pay yourself. Shifting money into salary can reduce that deduction.
• Retirement contributions. Some plan contribution limits are based on your W-2 wages, so a low salary can limit what you can put away.

LLC vs S corp side-by-side

When an S election is worth discussing with a CPA

There’s no official profit threshold, and you’ll see different rules of thumb online. Instead of chasing a magic number, look for these signs:

• Profit is steady and comfortably above what a fair salary would be. The bigger the gap, the bigger the potential savings.
• You expect that profit to continue. Revoking an election and re-electing has waiting-period rules, so don’t elect for a single good year.
• You’re ready for payroll. Payroll means quarterly filings, W-2s and deposits on time. Missed deadlines carry penalties.
• Your state doesn’t wipe out the benefit. Check your state’s S corp taxes and fees.
• You don’t need investor-friendly share classes. If you’ll raise venture capital, an S corp is usually the wrong fit.

If most of these apply, bring your last 2 years of profit figures to a CPA and ask them to model both scenarios, including state taxes and retirement plans. Many CPA firms now use software that runs these comparisons quickly; see how technology is changing accounting and CPA firms.

Where to start: making the S election step by step

1. Form your LLC with your state if you haven’t already.
2. Get an EIN from the IRS. It’s free; our guide on how to get an EIN online walks through it.
3. Have your CPA set a reasonable salary and document how they chose it.
4. File Form 2553 with signatures from all shareholders. To take effect for the current tax year, it generally must be filed no more than 2 months and 15 days after the year begins, or at any time during the prior year. The IRS offers relief for some late elections under Rev. Proc. 2013-30.
5. Set up payroll before you take your first salary payment.
6. Keep clean books. Distributions, salary and reimbursements need to be recorded properly. Good small business accounting software helps.
7. Adjust your estimated taxes. Withholding from your salary covers part of your tax, but you may still need to pay quarterly estimated taxes on distributions.

If you also hire help, make sure you classify workers correctly. Our guide to 1099 contractors vs W-2 employees covers the rules.

Conclusion

An LLC is about legal structure, and an S corp is about how the IRS taxes your profit. Staying a default LLC is simpler and often right in the early years. Once your profit is steady and well above a fair salary for your role, an S election can cut Social Security and Medicare tax, but only after payroll costs, state taxes and the reasonable salary rule are counted. Run the numbers with a CPA before you file Form 2553.

Sources

• IRS: S corporations — eligibility rules, Form 2553 and pass-through taxation
• IRS: S corporation compensation and medical insurance issues — reasonable compensation requirement and IRS warnings
• IRS: Instructions for Form 2553 — election deadline and late election relief
• SSA: Contribution and benefit base — 2026 Social Security wage base of $184,500
• IRS: Topic no. 751, Social Security and Medicare withholding rates — payroll tax rates and Additional Medicare Tax thresholds
• California Franchise Tax Board: S corporations — 1.5% rate and $800 minimum franchise tax