S-Corp vs LLC Taxes FAQ

This is one of the most misunderstood topics in small business taxation. An LLC (Limited Liability Company) and S-Corp are fundamentally different concepts - one is a legal entity type, and the other is a tax election.

LLC as a Legal Entity:

An LLC is a business structure formed under state law that provides liability protection. For tax purposes, the IRS doesn't recognize "LLC" as a tax classification. Instead, LLCs choose how they want to be taxed:

• Single-member LLC: Defaults to "disregarded entity" status - taxed like a sole proprietorship on Schedule C
• Multi-member LLC: Defaults to partnership taxation on Form 1065
• LLC electing corporate treatment: Can choose C-Corp or S-Corp taxation

With default LLC taxation, all net income passes through to owners and is subject to self-employment tax - 15.3% combined Social Security (12.4%) and Medicare (2.9%) tax on the first $168,600 of earnings (2024), plus 2.9% on amounts above that threshold.

S-Corp as a Tax Election:

An S-Corp is a tax classification under IRC Section 1362 that any qualifying LLC or corporation can elect. With S-Corp taxation:

• You must pay yourself a "reasonable salary" as an employee (subject to payroll taxes)
• Remaining profits pass through as distributions NOT subject to self-employment/payroll tax
• The business files Form 1120-S and issues Schedule K-1s to shareholders

The key benefit: S-Corp taxation can significantly reduce overall tax burden for high earners by limiting the amount subject to employment taxes. Instead of 15.3% SE tax on all net income, you only pay payroll taxes on reasonable salary.

Reasonable compensation is the salary an S-Corp must pay to shareholder-employees who perform services for the corporation. This is perhaps the most critical and contested aspect of S-Corp taxation, and the IRS scrutinizes it heavily.

The legal requirement:

Under IRC Section 3121 and related regulations, S-Corp shareholders who perform services must receive wages that reflect the value of those services before any distributions are made. You cannot simply take all profits as distributions to avoid employment taxes.

Factors the IRS considers when evaluating reasonable compensation:

• Comparable salaries: What similar businesses pay for similar positions in your industry and geographic area
• Time and effort: Hours worked and the nature of duties performed
• Training and experience: Your qualifications, education, and expertise
• Company size and complexity: Larger, more complex businesses justify higher salaries
• Company financial position: Profits, revenue, and growth patterns
• Dividend history: Pattern of salary vs. distributions over time
• Compensation agreements: Formal employment agreements and policies

Practical guidelines:

• Research comparable salaries using Bureau of Labor Statistics data, salary surveys (Glassdoor, PayScale, Salary.com), and industry associations
• If you actively work in the business, salary should reflect what you'd pay an employee to do your job
• Document your analysis in case of IRS examination
• Consider a 60/40 split rule of thumb: salary equal to at least 60% of total compensation (salary + distributions), though this is just a starting point, not an IRS rule

Warning signs that trigger audits: Taking minimal salary with large distributions, especially when the shareholder provides most of the business's services and the business is highly profitable.

S-Corp tax savings come from avoiding self-employment tax (15.3%) on profits taken as distributions rather than salary. However, calculating actual savings requires considering multiple factors.

Basic savings calculation example:

Business nets $150,000 in profit. You're the sole shareholder-employee.

Without S-Corp (default LLC Schedule C):

• Self-employment tax on $150,000: approximately $21,068 (after the SE tax deduction adjustment)
• Plus income tax on $150,000 adjusted for SE deduction

With S-Corp election:

• Reasonable salary: $75,000
• Payroll taxes on $75,000: $11,475 (employer + employee FICA)
• Distribution: $75,000 - no SE/payroll tax
• Savings: approximately $9,593

Factors that reduce actual savings:

• Employer payroll taxes are deductible: The employer portion (7.65%) reduces taxable income, partially offsetting savings
• S-Corp administrative costs: Payroll service ($300-$1,500/year), additional tax preparation fees ($500-$2,000+), potential legal/accounting setup costs
• California state taxes: S-Corps pay 1.5% tax on net income (minimum $800), plus the $800 franchise tax
• Reasonable salary limits: The more services you provide, the higher your required salary, reducing distribution amounts
• Reduced Social Security benefits: Lower wages mean lower future Social Security benefits

General rule of thumb: S-Corp election typically makes sense when net profits consistently exceed $50,000-$80,000 annually after paying a reasonable salary, and savings exceed administrative costs by a meaningful margin.

Use our tax calculators at Terms.Law/Calcs to model your specific situation.

Timing your S-Corp election correctly requires analyzing both your current financial situation and your readiness for increased administrative requirements.

Signs you're ready for S-Corp election:

• Consistent profitability: Net business income reliably exceeds $50,000-$80,000 annually
• Room for distributions: You can pay yourself a reasonable salary AND have meaningful profits left over (at least $20,000-$30,000 for distributions)
• Administrative readiness: You're prepared for payroll processing, quarterly tax deposits, and more complex tax returns
• Tax savings exceed costs: Projected savings outweigh added compliance costs ($1,500-$3,000+ annually)
• Stable business model: Predictable income makes salary planning easier

Red flags that S-Corp may not be right:

• Highly variable income: Unpredictable revenue makes salary planning difficult
• Expected losses: S-Corp losses have "at-risk" and "basis" limitations that may defer loss deductions
• Low profit margins: If most revenue goes to expenses, there's little left to distribute tax-efficiently
• Plans for investors: S-Corp restrictions (100 shareholders, one class of stock, no foreign owners) complicate equity raises
• Passive income business: If you're not actively working in the business, reasonable salary requirements are minimal or non-existent, eliminating the main S-Corp benefit

Election deadlines:

• New entities: File Form 2553 within 75 days of formation for immediate S-Corp treatment
• Existing entities: File Form 2553 by March 15 for the election to be effective for the current calendar year
• Late elections: Revenue Procedure 2013-30 allows late elections with reasonable cause if certain conditions are met

California imposes unique taxes on both LLCs and S-Corps that significantly impact the choice between entity structures. Understanding these state-level costs is essential for California businesses.

California LLC Taxes:

• $800 minimum franchise tax: Due annually regardless of income (waived for first year for new LLCs formed after January 1, 2021)
• LLC fee based on total income: This is in addition to the $800 and is based on gross receipts, not net income:
  • $0 - $249,999: No fee
  • $250,000 - $499,999: $900 fee
  • $500,000 - $999,999: $2,500 fee
  • $1,000,000 - $4,999,999: $6,000 fee
  • $5,000,000+: $11,790 fee

California S-Corp Taxes:

• $800 minimum franchise tax: Due annually regardless of income
• 1.5% tax on net income: Calculated on California net income, with the $800 serving as a minimum
• Example: S-Corp with $200,000 net income pays $3,000 (1.5% x $200,000), since this exceeds $800

Comparing state costs:

For high-revenue businesses, S-Corp taxation often results in lower California taxes. Example:

• Business with $1,000,000 revenue and $300,000 net income
• As LLC: $800 + $6,000 fee = $6,800
• As S-Corp: $800 minimum or 1.5% of $300,000 = $4,500 (greater of the two)
• S-Corp saves $2,300 at the state level alone

Important California considerations:

• The California Franchise Tax Board scrutinizes S-Corp salaries just like the IRS
• California does NOT conform to federal qualified business income (QBI) deduction
• Both LLCs and S-Corps must file California returns even if operating at a loss
• First-year franchise tax waiver for new LLCs doesn't apply to LLCs electing S-Corp status

To qualify for S-Corp election under IRC Section 1361, your business must meet specific eligibility requirements. Failing any of these requirements terminates S-Corp status, potentially triggering adverse tax consequences.

Entity requirements:

• Must be a domestic corporation (formed under U.S. law) OR an LLC that elects to be treated as a corporation
• Cannot be an "ineligible corporation" - certain financial institutions, insurance companies, and domestic international sales corporations (DISCs) are excluded

Shareholder requirements:

• 100 shareholder limit: No more than 100 shareholders (family members can elect to be treated as one shareholder under IRC Section 1361(c)(1))
• Eligible shareholders only:
  • U.S. citizens and resident aliens: YES
  • Certain trusts (grantor trusts, QSSTs, ESBTs): YES
  • Estates: YES
  • Tax-exempt organizations under 501(c)(3) and 401(a): YES
  • Partnerships and LLCs: NO
  • Corporations: NO
  • Non-resident aliens: NO

Stock requirements:

• One class of stock: All shares must have identical rights to distribution and liquidation proceeds
• Voting rights can differ (voting vs. non-voting shares are permitted)
• Debt instruments that are treated as equity for tax purposes can cause second-class-of-stock problems

Making the election:

1. File Form 2553 (Election by a Small Business Corporation) with the IRS
2. All shareholders must consent by signing the form
3. For LLCs: May need to first file Form 8832 to elect corporate treatment, though this can often be done simultaneously on Form 2553

Election deadlines:

• New entities: Within 75 days of formation for current-year effectiveness
• Existing entities: By March 15 of the year the election is to take effect
• Late elections: Possible under Rev. Proc. 2013-30 with reasonable cause

Setting your S-Corp salary unreasonably low is one of the most common and costly S-Corp mistakes. The IRS actively audits S-Corps for inadequate officer compensation, and the consequences can be severe.

IRS audit triggers for S-Corp salaries:

• Zero or minimal salary with substantial distributions
• Salary significantly below industry norms for your position
• Profitable business with shareholder-employees taking only distributions
• Pattern of increasing distributions while salary remains flat
• Shareholder provides most services but takes minimal compensation

Consequences of IRS reclassification:

If the IRS determines your salary was unreasonably low, they will reclassify a portion of your distributions as wages. This triggers:

1. Back employment taxes: Both the employer portion (7.65% FICA) and employee portion (7.65% FICA) must be paid on reclassified amounts
2. Failure-to-deposit penalties: Up to 15% of the tax due for failing to make timely payroll tax deposits
3. Accuracy-related penalties: 20% of the underpayment under IRC Section 6662
4. Interest: Compounding daily from the original due date at the federal short-term rate plus 3%
5. Potential fraud penalties: In egregious cases, 75% civil fraud penalty under IRC Section 6663

Landmark court cases:

• Watson v. Commissioner (2012): Accountant paid himself $24,000 salary on $200,000+ profits. Court upheld IRS reclassification of $67,044 in distributions as wages.
• Radtke v. United States (1989): Attorney took zero salary and all compensation as dividends. Court held ALL payments were wages subject to employment tax.
• Joly v. Commissioner (2016): S-Corp owner paid low salary relative to distributions. Court found reasonable salary should have been significantly higher.

Protective measures:

• Document your salary analysis with industry research
• Maintain written compensation policy
• Pay consistent, regular wages (not sporadic lump sums)
• Consult with a tax professional before setting initial salary

Yes, absolutely. There is no minimum number of shareholders required for an S-Corp. A single-member LLC can elect S-Corp taxation, and a single-shareholder corporation can make the S-Corp election. In fact, single-owner S-Corps are extremely common among self-employed professionals and small business owners.

How to set up a single-owner S-Corp:

Option 1: Form a corporation and elect S-Corp status

1. Form a corporation with your state (articles of incorporation)
2. File Form 2553 with the IRS to elect S-Corp status
3. You're the sole shareholder and typically sole director/officer

Option 2: Form an LLC and elect S-Corp taxation

1. Form an LLC with your state (articles of organization)
2. File Form 8832 (Entity Classification Election) to be treated as a corporation, OR
3. File Form 2553 which can serve as both the corporate election and S-Corp election simultaneously

Operational requirements as a single-owner S-Corp:

• Reasonable salary: You must pay yourself reasonable compensation for services performed (same rules apply as multi-owner S-Corps)
• Payroll processing: Run regular payroll, withhold taxes, file quarterly Form 941s, issue yourself a W-2
• Separate bank account: Keep business and personal finances strictly separated
• Annual filings: File Form 1120-S (S-Corp return) and receive Schedule K-1 showing your share of income
• State requirements: File applicable state S-Corp returns (California Form 100S)

Common misconception:

Some single owners believe they can avoid the reasonable salary requirement because they don't technically "employ" themselves. This is incorrect. Courts have consistently held that shareholder-employees who perform services must receive reasonable wages before taking distributions. The fact that you're the only owner doesn't change this fundamental S-Corp requirement.

Is it worth it for a single owner?

The same analysis applies as for any S-Corp: if your net profits consistently exceed $50,000-$80,000 after paying yourself a reasonable salary, and the tax savings outweigh administrative costs, S-Corp election makes sense regardless of ownership structure.