Few questions come up more often with growing business owners: should my LLC stay as it is, or should it be taxed as an S corporation? The answer depends on your profits, your role in the business, your state, and your goals. This article explains the tax mechanics so you can have a more informed conversation with your advisors.
An LLC is a legal structure, not a tax classification
A limited liability company is created under state law. For federal tax purposes, the IRS treats it differently depending on how many owners it has and what elections it makes. By default, a single-member LLC is taxed as a sole proprietorship (“disregarded entity”), and a multi-member LLC is taxed as a partnership. An LLC can also elect to be taxed as a corporation, including an S corporation, if it qualifies.
How the default LLC is taxed
- Profit passes through to the owners’ personal tax returns. The LLC itself generally does not pay federal income tax.
- Owners generally owe self-employment tax (Social Security and Medicare) on their share of net earnings from the business.
- Owners typically make quarterly estimated tax payments instead of having tax withheld.
How an S corporation election changes things
An S corporation is also a pass-through entity, so profit still flows to the owners’ personal returns. The difference lies in how owner income is characterized:
- Owners who work in the business must generally be paid a reasonable salary, which is subject to payroll taxes and run through payroll.
- Remaining profit may be distributed to owners as distributions, which are generally not subject to self-employment tax.
- The company must file its own business return and the owners receive a Schedule K-1.
Why the election is not automatically better
Potential self-employment tax savings are the reason many owners consider an S corporation, but they come with trade-offs:
- Payroll and compliance costs. You will run payroll, file additional returns, and keep cleaner books.
- Reasonable compensation. Setting your salary too low is a well-known audit risk. What is reasonable depends on your role, experience, and the market.
- Eligibility rules. S corporations have restrictions on who can be a shareholder and how many classes of stock they can have.
- State treatment. Some states tax S corporations or impose franchise or entity-level taxes, so the federal picture is only part of the story.
- Other effects. The election can affect items such as retirement plan contributions, health insurance treatment for owners, and how you handle distributions and basis.
Questions to ask before deciding
- What are my expected profits over the next few years, not just this year?
- What salary would be reasonable for the work I do?
- Am I prepared for the added payroll and reporting requirements?
- How does my state treat the election?
- Do I plan to bring in partners, investors, or sell the business?
The bottom line
An S corporation election can be valuable for some owners and a poor fit for others. It is a decision to model with real numbers, ideally before the year begins, and alongside legal advice about your entity. We are glad to talk through your situation in a consultation.
General information only. This article is educational and is not tax, legal, or financial advice. Tax rules change and outcomes depend on your individual facts. Please consult a qualified professional about your situation.