LLC vs S Corp: What Each One Is and When to Choose

An LLC is a legal entity you form with your state. An S corporation is a tax status you elect with the IRS. They are not two options on the same menu: an LLC can be taxed as an S corporation, and most businesses that people call "S corps" are LLCs or corporations that filed Form 2553. The real question is whether your LLC should keep its default tax treatment or elect S corporation treatment, and that turns on profit, payroll and your state.

The one-sentence distinction

LLC answers "what is this business, legally?" It is created under a state statute by filing articles of organization (or a certificate of formation) and paying the state's fee, $35 to $520 depending on the state. It gives its owners, called members, limited liability for the company's debts, and it has no federal tax category of its own.

S corporation answers "how is this business taxed?" It is a set of rules in Subchapter S of the Internal Revenue Code that an eligible entity opts into by filing Form 2553. Profit and loss pass through to the owners' personal returns, the entity files an information return (Form 1120-S), and the owners who work in the business are paid a salary through payroll. A corporation can elect it; so can an LLC. Nothing is filed with the state to become one.

So the comparison most people want is really between two ways of taxing the same LLC: the default (a disregarded entity for one member, a partnership for several) and the S corporation election. That is how the rest of this guide treats it. If you are instead deciding between forming an LLC and forming a corporation, the entity choice is a separate question, and an LLC can still elect S status either way.

LLC (default tax) vs LLC taxed as an S corp: side by side

How an LLC taxed as an S corporation works

Nothing changes at the state. The LLC keeps its articles, its registered agent, its operating agreement and its annual report. What changes is the federal (and usually state) tax return and how the owners get paid.

1. The election. The LLC files Form 2553 with the IRS, signed by every member. The IRS treats a timely Form 2553 from an LLC as both an election to be taxed as a corporation and an election to be an S corporation; per IRS Publication 3402, an LLC does not need to file Form 8832 first.
2. Payroll. Each member who works in the business becomes an employee of it for payroll purposes. The LLC runs payroll, withholds income tax and the employee's share of Social Security and Medicare, pays the employer's share, files quarterly payroll returns and issues W-2s in January.
3. Distributions. Profit left after salary and expenses is distributed to members in proportion to ownership. Those distributions are reported on each member's K-1 and taxed as ordinary income on their personal return, but not subject to Social Security and Medicare tax.
4. The return. The LLC files Form 1120-S by March 15 (for a calendar year), issues K-1s, and the members report their shares. Most states want a matching state S corporation return, and some want a separate state election first.

An EIN is required for payroll and the 1120-S; if the LLC has been operating under its owner's Social Security number, it gets one before the election takes effect (the sequence is covered at llc-ein.com).

The reasonable salary rule

The saving in an S corporation comes from splitting profit into salary (taxed for Social Security and Medicare) and distributions (not taxed for them). The IRS's condition is that the salary be reasonable compensation for the work the owner actually does: what the business would have to pay someone else to do the same job. An owner who pays themselves a token salary and takes the rest as distributions is the classic audit target, and the IRS can reclassify distributions as wages, with back payroll tax, penalties and interest.

There is no published formula. Factors the IRS and the courts look at include the owner's duties and hours, the training and experience the role requires, what comparable businesses pay for the role, the company's gross and net income, and what the owner was paid before the election. Many owners and their CPAs land somewhere between 40% and 60% of profit for an owner who is the business, and higher where the owner is the only revenue producer. A CPA can confirm a figure you can defend, and document the reasoning in the file.

When does an S corporation start to pay off? A worked example

The arithmetic below is an illustration, not a projection. It uses the combined 15.3% Social Security and Medicare rate, a salary of 60% of profit, and ignores the deduction for half of self-employment tax, the qualified business income deduction, state taxes and the Social Security wage base, each of which moves the result. What it shows is the shape: the saving scales with profit, while the added cost of running an S corporation (payroll, a separate return, usually a CPA) is roughly fixed.

Set those gross savings against what the election costs to run. Payroll for a one-person company typically runs several hundred dollars a year; a Form 1120-S prepared by a professional typically adds a four-figure fee; and the states in the table below add their own tax or minimum. Many owners and CPAs treat somewhere around $60,000 to $120,000 of consistent net profit as the range where the saving starts to clear those costs, and well above it as the range where it clearly does. Below it, the default is simpler and often no more expensive. A CPA can run your actual numbers in an hour, and that hour is the right way to decide.

Form 2553 timing: when the election is due

The IRS instructions for Form 2553 set the deadline: the election must be filed no more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year preceding the tax year it is to take effect. For an LLC on a calendar year that wants S status from January 1, that means by March 15 of that year. A new LLC's first tax year starts the day it has members, assets or begins business, whichever is first, so a company formed on June 1 has until August 15 to elect for that first year.

Miss it and the election takes effect the following year, unless the IRS grants late-election relief. The IRS's standing relief procedure, Rev. Proc. 2013-30, lets an entity that intended to elect and had reasonable cause file a late Form 2553 within three years and 75 days of the intended effective date, with the statement the procedure requires; the instructions explain the exact wording. Both rules and the eligibility requirements are in the Instructions for Form 2553 on irs.gov.

Who can elect

An LLC can elect S status only if it would qualify as a small business corporation. From the IRS instructions: no more than 100 owners; owners who are individuals, estates, certain trusts or certain exempt organizations, not corporations or partnerships; no nonresident alien owners; and one class of stock, which for an LLC means every member's share of profit and loss tracks their ownership percentage. An LLC whose operating agreement gives one member a preferred return, or whose members include another company or a non-US resident, cannot elect without changing those terms.

Does your state tax S corporations? State by state

Most states follow the federal election and tax S corporation income only on the owners' personal returns. The exceptions are where the decision changes. District of Columbia, Louisiana, New Hampshire, Tennessee and Texas do not recognize S corporation status at the entity level and tax the company regardless. New York requires a separate state election. And California, Illinois, Massachusetts, Michigan, Nevada, New Jersey, Ohio and Washington follow the election but charge an entity-level tax or minimum that an S corporation (or an LLC taxed as one) pays anyway. The 37 jurisdictions not listed follow the federal election with no entity-level S corporation tax, as far as their revenue departments publish; a CPA can confirm your state.

Three of these deserve a sentence each, because they are the states where owners most often get the comparison wrong.

• California. The $800 minimum applies to the LLC whether or not it elects. What changes is the formula above the minimum: an LLC pays the $800 plus a fee based on gross receipts, while an S corporation pays 1.5% of net income. For a business with high receipts and thin margins the S corporation formula can be lower; for a high-margin one, higher.
• Texas. The franchise tax ignores the election entirely; an LLC and an S corporation file the same report, and most small companies owe nothing under the threshold. The S election saves federal payroll tax here just as elsewhere, with no state effect either way.
• New York. The federal election does nothing for New York until Form CT-6 is filed, and a New York City business pays the city's General Corporation Tax as an S corporation regardless. Owners in the city should have a CPA compare the whole picture before electing.

When staying a default LLC makes sense

• Profit is below, or inconsistently around, the range where the saving clears the added running costs.
• The owner draws most of the profit as compensation anyway, leaving little to distribute.
• The LLC has, or wants, owners an S corporation cannot have: another company, a non-US resident, more than 100 people.
• Members share profit unequally relative to ownership, which the one-class-of-stock rule forbids.
• The business holds appreciating assets or rental property, where the pass-through rules of a default LLC are usually the better fit and the self-employment tax saving does not arise.
• The owner lives in a state that taxes S corporations at the entity level and the state cost eats the federal saving.
• The owner would rather not run payroll on themselves.

When the election is worth a serious look

• Net profit is consistently well above what the owner would reasonably be paid as salary for the work.
• The owners are all US individuals with ownership that matches their profit shares.
• The business already runs payroll for employees, so adding the owners costs little.
• The state follows the federal election with no entity-level tax, or the entity tax is small next to the saving.

The order of operations

1. Form the LLC with the state (the steps are in how to start an LLC; the fees, median $100, are in LLC cost by state).
2. Get the LLC's EIN and open its bank account.
3. Operate under the default taxation while profit is finding its level.
4. When profit is consistently in the range where the saving clears the running costs, have a CPA confirm the numbers, set a defensible salary and file Form 2553 within the deadline, plus any state election.
5. Run payroll from the effective date, keep salary and distributions separate in the books, and file the 1120-S each March.

If you are earlier than all of this and still deciding whether to form an entity at all, LLC vs sole proprietorship is the comparison to read first.