S-Corp vs LLC: The Real Tax Differences for Small Business Owners

The core difference comes down to one thing: how much of your profit gets hit with self-employment tax. An LLC (taxed as a sole proprietor or partnership by default) applies that 15.3% tax to everything you earn. An S-corp lets you split your income into a salary and distributions — and only the salary portion goes through payroll taxes.

That's the short version. Here's how it actually works.

What Is an LLC for Tax Purposes?

An LLC is a legal structure, not a tax category. The IRS doesn't have a tax form called "LLC."

When you form a single-member LLC and don't make any special election, the IRS treats you like a sole proprietor. Your business profit flows to Schedule C on your personal return. All of that net profit — every dollar — is subject to self-employment tax.

A multi-member LLC defaults to partnership taxation. Income passes through to each partner's personal return via Schedule K-1, and each partner generally owes SE tax on their share of business income.

The LLC gives you legal liability protection. Tax-wise, you're still paying self-employment taxes on everything.

What Is an S-Corp for Tax Purposes?

An S-corp is a tax election, not always a separate legal entity. You can form a corporation and elect S-corp status — or you can form an LLC and elect to be taxed as an S-corp. Both routes get you to the same place for federal tax purposes.

The election is made by filing Form 2553 with the IRS. There are deadlines: generally within 75 days of the start of the tax year you want the election to apply. Miss the window and you're waiting until the following year (though late-election relief exists in some cases).

Once the election is in effect, the business files Form 1120-S each year. You, as a shareholder-employee, receive a W-2 for your salary and a Schedule K-1 for your share of any remaining profit.

Where the Tax Savings Actually Come From

Self-employment tax is 15.3% on the first ~$168,600 in net earnings (2024 Social Security wage base — this figure adjusts annually), then 2.9% Medicare on everything above that. As a sole proprietor, that entire rate applies to your net profit.

An S-corp changes the structure:

| Income type | Subject to payroll/SE tax? |
|---|---|
| W-2 salary from your S-corp | Yes — both employee and employer share |
| S-corp distributions (profit above salary) | No |

If your business earns $200,000 in profit and you pay yourself a $90,000 salary, only that $90,000 runs through payroll taxes. The remaining $110,000 passes to you as a distribution, not subject to self-employment or payroll taxes.

That difference can be meaningful.

What "Reasonable Compensation" Actually Means

The IRS is aware of the salary-vs-distribution strategy and has a rule: S-corp shareholder-employees must pay themselves a reasonable salary for the work they actually do.

This isn't a loophole you can collapse to zero. If you're a full-time consultant earning $250,000 through your S-corp and you pay yourself a $20,000 salary to minimize payroll taxes, that's a red flag. The IRS can reclassify distributions as wages — and bill you for the back taxes, penalties, and interest.

Reasonable compensation looks at what you'd pay someone else to do your job in your industry. There's no formula. Many practitioners use comparable salary data to document the number. The point: don't game this aggressively. Pay yourself something defensible.

What It Costs to Run an S-Corp

The potential tax savings come with overhead. Before you run the numbers, account for:

Payroll processing. You'll need to run payroll at least quarterly, file Form 941 each quarter, and issue yourself a W-2 at year-end. Most small business owners use a payroll service. Budget $500–$2,000/year depending on the provider.
Business accounting. You need cleaner books than a Schedule C filer. The S-corp files its own tax return (Form 1120-S), which is more involved than adding a Schedule C.
Tax preparation fees. An S-corp return typically costs more to prepare than a sole proprietor's return.
State-level fees. Some states charge S-corps annual franchise taxes or minimum fees regardless of income. Check what your state requires — it can erode savings at lower income levels.

When Does an S-Corp Actually Make Sense?

There's no universal threshold, but most tax professionals won't suggest the S-corp election below roughly $50,000–$80,000 in consistent annual net profit. Below that, the payroll costs and compliance overhead often eat most or all of the tax savings.

The math improves as income rises. At higher profit levels, the spread between your salary and your distributions grows, and the savings from keeping distributions out of payroll tax become more significant.

A few other factors:

Consistent income matters. If your revenue swings dramatically year to year, the fixed costs of running payroll can sting in lean years.
Health insurance treatment. S-corp shareholder-employees who own more than 2% of the company have specific rules around deducting health insurance premiums. It's not complicated, but it's a detail that a sole proprietor doesn't have to manage.
Retirement contributions. The way you structure contributions to a SEP-IRA or Solo 401(k) changes under S-corp status. In some situations this is a benefit; in others it requires more planning.

One Thing That Doesn't Change

Both structures are pass-through entities for federal income tax. Your business profit gets taxed on your personal return — you don't face a second layer of tax at the entity level. That's different from a C-corp, where the business pays corporate income tax and shareholders pay tax again on dividends.

Neither an LLC nor an S-corp shelters you from income tax. They both affect self-employment and payroll taxes, not your ordinary income tax rate.

How to Think About This Decision

If you're a sole proprietor making solid income and curious whether an S-corp election might make sense, the right first step is a breakeven analysis. Take your current net profit, subtract a defensible reasonable salary, and calculate the SE tax you'd avoid on the remainder. Then subtract the payroll and accounting costs you'd add. What's left is your actual estimated savings.

Do that before you file Form 2553. The election isn't automatically beneficial — and once made, unwinding it has restrictions.

This article is general educational information about federal tax concepts and is not personalized tax advice for your specific situation. Tax rules, thresholds, and state requirements change. Work with a qualified tax professional before making entity or election decisions.

Frequently asked questions

Is an LLC itself a federal tax category?

No. A single-member LLC defaults to sole-proprietor treatment, while a multi-member LLC defaults to partnership taxation.

Why can an S-corp reduce payroll taxes?

Reasonable W-2 salary is subject to payroll tax, while distributions above salary are not.

Do both structures still pass income through?

Yes. Both are pass-through structures for federal income tax as described in the article.