Last Updated: February 16, 2024, 2:18 pm by TRUiC Team


When Should You Choose to be Taxed as an S Corp Over an LLC?

As a business owner, you’re used to making decisions that affect your company finances. If you have a limited liability company (LLC), there is one question that has the potential for significant tax savingswhen should you choose to be taxed as an S corp over an LLC? An S corporation (S corp) is a tax classification elected by an LLC or a corporation that can help business owners save on self-employment taxes.

S corps offer tax advantages and other benefits under the right circumstances. That said, business owners converting a sole proprietorship or a partnership to an LLC may want to think about electing S corp status. If you are starting an LLC or already have one, and are considering starting an S corp, read our When Should You Choose to be Taxed as an S Corp Over an LLC guide to learn more and find out if the S corp status is right for your business.

Recommended: If you’re a solopreneur making at least $60,000 in earnings with $20,000 in annual distributions, looking for business tax savings, let Collective start your S corp or elect S corp status for your LLC. The professional service handles your paperwork, monthly accounting, and more.

Entrepreneur writing tax calculations for S Corp in a journal

What Is an S Corporation?

An S corporation (S corp) is a tax classification assigned by the Internal Revenue Service (IRS) that can be elected by an LLC or a corporation; It is also known as Subchapter S. Many business owners ask, when should you choose to be taxed as an S corp over an LLC? 

If you’re considering starting an S corp, your business must first meet S corp requirements (listed below) to qualify and then file Form 2553 for your S corp status to take effect. In an S corp, an owner is an employee and is paid a reasonable salary and distributions. 

You should consider starting an S corp when your company can pay owner salaries and distributions that allow them to offset S corp costs (more on this later). This is because S corp distributions are only subject to income tax, saving owners/shareholders on self-employment taxes.

Pass-Through Taxation

Business structures such as sole proprietorships, partnerships, and default LLCs have pass-through taxation, which means that the business does not pay taxes at the corporate level (check your state for exceptions). Pass-through taxation allows business profits, credits, deductions, and losses to be passed directly to business owners (shareholders), who are taxed on their individual income tax returns at their ordinary tax rate.

The S corp tax designation has pass-through taxation and offers limited liability protection (personal assets are protected from debtors and lawsuits). For this reason, among others, an S corp is a preferred choice for small business owners. It combines the best attributes of LLCs and corporations into one tax structure with tax advantages.

Key Takeaways:

  • An S corp is a tax status elected by LLCs and corporations
  • The IRS has specific S corp requirements to qualify
  • The S corp classification provides tax benefits
  • S corps have distributions and a reasonable salary
  • Owners (shareholders) are employees and U.S. citizens or permanent resident aliens
  • You should choose to be taxed as an S corp when your business can save enough on distributions to offset other costs
  • S corps have pass-through taxation

S Corp Requirements

The IRS is clear on its S corp requirements. For a business to elect S corp status, the following must apply:

  • 100 shareholders or less
  • Must be a domestic LLC or corporation
  • Issue only one class of stock
  • Shareholders are U.S. citizens or permanent resident aliens
  • Are owned by private individuals

S Corp Reasonable Salary

Business owners in an S corp are considered salaried employees. However, owners must pay themselves what the IRS considers a reasonable salary. This means that the salary should reflect what a typical position would pay for the type of job and level of experience. 

The IRS will pay close attention to owner salaries to ensure that it is not low to avoid paying more on taxes. S corp tax advantages are based on an owner’s salary, which determines how much will be paid out in distributions — resulting in the amount of tax savings you’ll get. You can visit websites like Glassdoor to get a better idea of what to pay yourself. 

S Corp Tax Benefits

Simply put, S corp tax benefits are the reason a business chooses to be taxed as an S corp. Generally, an employer pays over 7% in employee taxes and the other over 7% is paid by the employee. For a self-employed business owner, the entire tax amount must be paid by that owner/shareholder, which amounts to over 15% in total. Self-employment taxes include FICA (Social Security and Medicare) taxes.

In an S corp, a business owner becomes a salaried employee to reduce the tax burden. This is because the owner is paid in two ways: salary and distributions. This distinction imposes self-employment taxes (15.3%) and income tax on the salary portion. However, the distributions are only subject to income tax, saving the business owner 7.65% (half of around 15.3%) in self-employment taxes on the distribution portion.

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If you’re a solopreneur, let Collective start your S corp, handle your monthly accounting, and more.

S Corp vs LLC Taxes

S corps and default LLCs differ in tax structure. For some business owners, an S corp may be a better choice, while others may see that a default LLC meets their business needs. A few factors, such as costs, earnings, and distributions, should be considered before choosing S corp vs. LLC. We’ll explain S corp vs. LLC taxes below.

Default LLC Taxes

In a default LLC, a business owner who, for example, makes $100,000 a year and pays $15,000 in annual business expenses with annual net profits (i.e., profits after business expenses) of $85,000 is taxed differently than in an S corp. The $85,000 are passed directly to the owner/shareholder in the form of distributions due to pass-through taxation.

Default LLC Taxes Example Above:

  • $100,000 (business income) - $15,000 (expenses) - $0 (no owner salary in a default LLC) = $85,000 in distributions
  • $85,000 - 15.3% (self-employment taxes) = $13,005 owed in  self-employment taxes alone
  • In addition to self-employment taxes, you’ll also pay income tax on the $85,000

Here's a Recap on How Taxes Work in a Default LLC:

Out of the $85,000 in distributions from the example above, the owner has to pay both:

  • Self-employment taxes (15.3% tax rate)
  • Income tax

S Corp Taxes

In an S corp, a business owner gets paid a reasonable salary. In this case, for example, the annual salary is $65,000. Therefore, a business owner making $100,000 in annual profits, paying $15,000 in annual expenses, with an annual salary of $65,000, has $20,000 in distributions after expenses (i.e., business costs). 

S Corp Taxes Example Above (with salary and distributions):

$100,000 (business income) - $15,000 (expenses) - $65,000 (owner salary) = $20,000 in distributions

  1. Taxed Distributions
    $20,000 - $0 (no self-employment tax) - income tax = less taxes paid since no self-employment tax on the $20,000 amount
  2. Taxed Salary
    $65,000 (salary) - 15.3% (half paid by the business, half by the owner-employee) = $9,945

Here's a Recap on How Taxes Work in an S Corp

  • The $65,000 salary portion is subject to self-employment taxes and income tax
  • The $20,000 distributions are only subject to income tax, but not self-employment taxes
  • S corp tax savings come from paying less on taxes on the $20,000 distributions portion
  • In a default LLC without S corp tax status, the owner/shareholder would have to pay both self-employment taxes and income tax on the full $85,000 amount.

S Corp Tax Savings

By breaking down business income into salary and distributions in an S corp, the owner’s salary pays the bulk of the taxes. The distributions get a tax break, saving the owner thousands of dollars on self-employment taxes, which for most businesses is a significant amount of money.

Self-Employment Taxes: Default LLC vs. S Corp Tax Savings

Business owners interested in S corp status can enjoy S corp tax savings. Below is a comparison between the default LLC vs. S corp tax savings, showing the differences in taxation from the examples above.

  • S corp pays $9,945 in self-employment taxes (business pays half, owner pays the other half)
  • Default LLC pays $13,005 in self-employment taxes
  • Difference in taxes $13,005 (default LLC) - $9,945 (S corp) = $3,060 in S corp tax savings

Calculate Your S Corp Tax Savings

S Corp Savings Calculator

Calculate how much you can save by choosing an S Corp tax classification

Recommended: Are you a solopreneur looking to start your S corporation? Collective can take care of all your S corp needs.

When to Choose to Be Taxed as an S Corp Over an LLC

By now, you may know that under the right circumstances, S corp tax status allows business owners to pay fewer taxes on their earnings. We recommend that you start an S corp when your annual business income is at least $60,000 with $20,000 in distributions, including owner salary.

You should elect to be taxed as an S corp if these four things are true:

  • You know you’ll want to take a substantial portion of money out of your business rather than reinvest profits to grow the business, year over year
  • You know your business will generate enough profit to pay the owner(s) a reasonable salary and at least $20,000 in annual distributions
  • Your business is an LLC or corporation
  • The business meets S corp requirements

S Corp Costs

Business owners who want to start an S corp should consider S corp costs. Starting an LLC or a corporation involves business formation fees, which can range from $0 to over $800. There are also annual regulatory costs, such as the annual or biennial report (depending on the state). You’ll also have to hire a payroll and accounting professional. 

Overall, the total costs should be offset by the S corp’s tax savings. We estimate that distributions should add up to at least $20,000 a year to justify the additional expense. You can hire a professional service like Collective to manage all your S corp paperwork and needs from S corp formation to monthly accounting — all for a tax-deductible fee.

FAQs

An S corporation (S corp) is a tax status that can be elected by an LLC or corporation. LLCs and corporations offer limited liability protection. A business owner will not lose liability protection by electing S corp tax status.

Subchapter S Form 1120S is available on the IRS website.

Yes, subchapter S is the same thing as an S corp.

Yes, an S corp files taxes at the state and federal levels.

Learn more with our S Corp Tax Rate guide.

The default LLC tax status is better for small businesses that reinvest profit to grow their business. An S corp is better for businesses that have enough net profit to pay owners a reasonable salary and at least $20,000 in distributions.

Learn more with our LLC vs. S Corp guide.

Yes, S corp income passes through to the owner’s individual tax returns and is subject to state income taxes.

Learn more with our S Corp Tax Rate guide.

Yes, an S corp owner must take a reasonable salary per IRS guidelines. Reasonable is defined as being a fair market salary for the work performed.

Owners of an S corp are not considered self-employed for tax purposes. S corp owners are treated as employees and can reduce their tax burden by not having to pay self-employment taxes.

A reasonable salary is any salary that you would pay someone to do the same job. To determine a reasonable salary for your position, you can compare similar salaries on websites like Glassdoor or the US Bureau of Labor Statistics.

Learn more with our What Is an S Corp guide.

S corp owners pay themselves a reasonable salary and distributions.

Learn more with our What Is an S Corp guide.

Yes. In fact, it only makes sense to elect S corp tax status if you are going to be able to consistently take an annual draw of $20,000 or more and also pay yourself a reasonable salary.

Learn more with our S Corp Taxes guide.

You get money out of your S corp by paying yourself a reasonable salary and distributions.

Learn more with our What Is an S Corp guide.

Yes. S corp distributions count as income, but you don’t have to pay self-employment taxes on distributions as you would in a default LLC.

Learn more with our S Corp Taxes guide.

S corp distributions are only subject to federal and state income tax. Distribution income passes through to the owner’s individual tax return and is taxed based on the individual’s tax bracket and filing status.

Learn more with our S Corp Taxes guide.

S corp distributions are reported on Schedule E of your federal income tax return.

Learn more with our S Corp Taxes guide.