Key Takeaways

  • LLCs and S corps offer different tax treatments, with potential savings on self-employment taxes when structured correctly.
  • An S corp allows business owners to split income into salary and distributions, reducing self-employment tax liability.
  • Electing S corp status for your LLC may bring savings, but it requires careful compliance with IRS guidelines.
  • Reasonable compensation is critical to remain compliant with the IRS and avoid penalties.
  • Both structures have administrative and legal implications that must be weighed against tax advantages.
  • Certain professions and income levels benefit more from an S corp tax structure.
  • State-level taxes and fees can impact whether an S corp election is beneficial.
  • UpCounsel can connect you with experienced tax attorneys to evaluate your best structure.

Self Employment Tax LLC vs S Corp

With self employment tax LLC vs S corp, both entities offer tax advantages, and you can combine the two. Many business owners choose the LLC structure instead of using an S corp because LLCs offer greater flexibility and require less formalities. With that, combining an S corp with an LLC has its advantages, depending on your business goals.

If a business owner participates in the business, the owner must pay self employment taxes. As of 2013, self employment taxes apply to the first $113,700 of wages, net earnings, and tips. Such earnings are also called earned income. When it comes to an S corp, they must pay self employment taxes on services provided to the S corp. They do not pay taxes on profit distributions.

For LLCs, they are taxed in several ways. Sole-owner LLCs are taxed as a sole proprietorships, while multi-member LLCs are taxed as partnerships. Regardless, both LLCs must pay self employment taxes on the first $13,700 of income received. LLCs do not pay business income taxes. Instead, the owners would note the profits they receive on their individual tax returns.

LLCs can choose to be taxed as an S corp. An S corp itself is not a legal entity, but a tax designation from the IRS. This means that an LLC would fall under an S-corp tax classification instead of a sole proprietorship or partnership form of taxation. S corps have advantages, but they do come with more restrictions. If you are thinking of an S-corp tax classification, take note of the following parameters:

  • S corps cannot have over 100 shareholders
  • S-corp shareholders must be legal residents or U.S. citizens
  • Other entities cannot own an S corp, such as C corps, LLCs, and partnerships
  • S corps can only have one stock type (no tiered stock allowed)

To get an S-corp election, you must submit Form 2553 to the IRS, including Form 8832 in certain cases. For self employed people, they can choose an S-corp tax classification to avoid paying higher Medicare and Social Security taxes. Self employed people usually pay high Social Security and Medicare taxes (also called self employment taxes). With that, you should know that the IRS could take a closer look at your S corp since you’ll be paying lower self employment taxes overall.

Whether you’re an employee or self employed, you have to pay self employment taxes. When working for another individual, you only need to pay a part of the taxes, while your employer would pay the remaining tax owed. However, the self employed must pay all taxes. An employer-employee tax combination usually amounts to around 15.3 percent.

How S Corps Reduce Self-Employment Taxes

One of the primary reasons business owners consider S corp status is its potential to reduce self-employment taxes. In a typical LLC taxed as a sole proprietorship or partnership, all net earnings are subject to self-employment tax (currently 15.3%). However, when an LLC elects S corp taxation:

  • Only the salary paid to the owner-employee is subject to self-employment taxes.
  • Profit distributions are exempt from Social Security and Medicare taxes, although still subject to income tax.

This allows S corp owners to strategically split their income:

  • Example: If you earn $100,000, you might pay yourself a $60,000 salary (taxed with payroll/self-employment taxes) and take $40,000 as a distribution (not subject to those taxes), potentially saving thousands in self-employment taxes.

However, the IRS requires that the salary portion be "reasonable compensation" based on industry standards, experience, and role.

S-corp Benefit

For S-corp distributions, you may label a part of your income in the form of a salary and the other as a distribution. You must pay self employment taxes on the salary end of the income, but you’ll only pay regular taxes on the taxed distribution portion of the income. Overall, you can reduce your self employment tax balance drastically by dividing up your income in the right way.

Reasonable Compensation Guidelines

A critical aspect of S corp tax compliance is paying the business owner a reasonable salary before taking profit distributions. The IRS scrutinizes S corps that pay unreasonably low salaries in an attempt to avoid employment taxes.

When determining reasonable compensation, consider:

  • Job title and responsibilities
  • Experience and education
  • Industry norms and geographic region
  • Time devoted to the business

Failing to pay a fair wage can lead to IRS reclassification of distributions as wages, triggering back taxes, penalties, and interest.

S-corp Risks

The IRS tends to examine S-corp classification more closely due to the potential for abuse. For instance, if you make $300,000 in a single year, but only declare $20,000 as salary, you may get a response from the IRS because you’re trying to reduce a large portion of your self employment tax balance. To remedy this, you must give yourself a reasonable salary that’s not artificially low. What’s considered reasonable is up for debate, but the salary should match a typical salary range within your job position.

IRS Scrutiny and Audit Risk

The IRS keeps a close eye on S corps due to the risk of misclassification of income. Owners who pay themselves minimal salaries and take large distributions raise red flags.

To minimize audit risk:

  • Document how salary was determined
  • Maintain clear payroll records
  • Use benchmarks and industry data when setting compensation

Being proactive with compliance can protect your S corp tax savings from IRS penalties.

S-corp Drawbacks

An S corp may save you on self employment taxes in the short-term, but it could cost you in the long-run. As is the case with other corporations, an S corp comes with ongoing legal and accounting costs. Also, certain states compel you to pay added fees and taxes. For instance, an S corp in California must pay 1.5 percent on income with an annual $800 minimum tax balance. However, such a tax does not apply to sole proprietorships.

Additional Administrative Responsibilities

While the tax savings can be substantial, S corp status introduces new layers of complexity:

  • Payroll Requirements: Must run payroll and file related tax forms (e.g., 941, W-2).
  • Corporate Formalities: Must maintain meeting minutes, issue stock, and comply with annual filings.
  • Bookkeeping and Tax Filing: Must file IRS Form 1120-S annually and provide K-1s to shareholders.

These obligations may increase accounting costs and administrative overhead. For small businesses with limited revenue, the compliance burden may outweigh the tax benefit.

Is an LLC Right for You?

For many small businesses, LLCs offer more flexibility, especially if your business endeavors pertain to real estate. This is because corporations are subject to double taxation, one tax at the business level another when shareholders note their LLC earnings on their personal tax returns. On the other hand, LLCs do not pay business income taxes, and LLC members only pay taxes based on his or her share in the LLC.

When to Choose S Corp Status

S corp status isn’t ideal for every business. Here are some general guidelines for when it might make sense:

Consider an S corp if:

  • Your business consistently earns $50,000 or more in net profit
  • You’re actively involved in running the business
  • You can justify a reasonable salary and still retain profit for distributions
  • You want to reinvest savings from reduced self-employment tax

Stick with an LLC or other structure if:

  • Your profits are low or inconsistent
  • You’re in the early stages of business development
  • You prefer simpler tax filing and fewer formalities

Always consult with a qualified tax professional to model your tax scenarios and determine if electing S corp status will lead to real savings.

Frequently Asked Questions

1. What is the main difference between an LLC and an S corp for taxes?An LLC's entire profit is generally subject to self-employment tax, while an S corp allows the owner to split income into salary (taxed) and distributions (not subject to employment tax), potentially reducing overall tax liability.

2. How much can I save in self-employment tax by electing S corp status?Savings vary, but many business owners reduce their self-employment tax burden by thousands annually by shifting part of their income to distributions.

3. What qualifies as a reasonable salary for an S corp owner?A reasonable salary is one that reflects what someone in your role would typically earn in your industry, location, and level of experience.

4. Do I need to file separate tax forms if I elect S corp status?Yes. You must file Form 1120-S annually and provide shareholders with Schedule K-1s. You’ll also need to run payroll and file related employment tax forms.

5. Can a single-member LLC elect S corp taxation?Yes. A single-member LLC can file Form 2553 with the IRS to elect S corp tax treatment and take advantage of the associated tax benefits.

If you have more questions on self employment tax LLC vs S corp, submit your legal inquiry to our UpCounsel marketplace. UpCounsel’s will help you determine if an S-corp tax election would be the right move for your business. Also, they will provide more information on the benefits and drawbacks on registering for a corporate legal entity.