You’re chatting at a local business mixer when someone mentions switching their LLC to an S-Corp. They rave about the tax savings, claiming it was the best move they ever made. You nod, smile, and make a mental note. But you’re not actually sure what they did, or whether it’s something you should explore.
No need to worry: we will explain the S-Corp, its benefits, and drawbacks so you can make an informed decision about whether it is right for you.
Understanding LLCs and S-Corporations
Let’s start at the beginning. S-Corp elections have the potential to save some LLC owners thousands of dollars a year in taxes. But, like many things in tax planning, whether it will work for you is particular to your circumstances. To know whether it could work for you, it helps to understand what changes when you make the election, and what the IRS expects you to do once you’ve made it.
LLCs are one of the most common structures for small businesses. They’re relatively easy to set up, and they offer liability protection that keeps your personal assets separate from your business debts. From a tax perspective, LLCs are also flexible. By default, the IRS taxes a single-member LLC as a sole proprietorship. If there are multiple members, it’s taxed as a partnership. In either case, the business doesn’t pay taxes directly. The income flows through to your personal tax return.
That’s where the S-Corp option comes in. You can ask the IRS to treat your LLC like an S-Corporation for tax purposes. You don’t have to form a new business or dissolve your LLC. The change is purely about how your income is taxed.
Unpacking the Tax Implications
Let’s break it down into simple terms. Under default taxation, all your business profits are considered self-employment income. That means you pay income tax, and you also pay self-employment tax, which covers Social Security and Medicare. That self-employment tax rate is 15.3% and, as a business owner, you’re on the hook for the whole thing.
If you elect to be taxed as an S-Corp, you’re required to pay yourself a salary. That salary is taxed the same way any employee’s wages are. But any profits your business makes beyond that salary can be taken as distributions. Those distributions aren’t subject to self-employment tax. You still pay income tax on them, but you avoid the additional 15.3%.
For example: Let’s say your LLC makes $150,000 in profit this year. If you’re taxed as a sole proprietor, you’ll owe self-employment tax on all $150,000. With an S-Corp election, you might pay yourself a reasonable salary of $80,000 and take the remaining $70,000 as a distribution. In that case, only the $80,000 salary is subject to self-employment taxes. The result? A savings of over $10,000—possibly more.
That’s why this structure is so appealing. But it only works if you do it right.
The IRS expects your salary to be reasonable for your work. If you try to pay yourself too little and take the rest as a distribution, you risk triggering an audit. If that happens, the IRS can:
- Reclassify your income
- Impose penalties
- Bill you for back taxes
So, what counts as “reasonable”? There’s no one number. It depends on the work you do, your industry, your region, and how involved you are in the business. If you’re the primary operator—handling client service, operations, marketing, and admin—your salary should reflect that.
You don’t need to guess. There are tools and databases available that benchmark compensation by role and industry. A good advisor can help you arrive at a salary that’s well-supported.
Weighing the Administrative Responsibilities
Of course, along with tax benefits come new responsibilities. Once you become an S-Corp, you need to run payroll. That means issuing yourself paychecks, submitting payroll taxes, and filing employment forms with the IRS. You’ll also need to file a separate corporate tax return—Form 1120S—and provide yourself with a W-2 and a K-1.
These aren’t impossible tasks, but they’re necessary. Bookkeeping will become very important now (more than ever). An S-Corp requires more formal financial tracking. That includes monthly reconciliations, payroll reports, and documentation that supports your salary and distributions. Clean books aren’t just helpful for tax time—they’re your backup in case the IRS comes asking questions. If you have been managing your business out of a spreadsheet and a folder of receipts, you will need to upgrade your system. Most S-Corp owners either hire a payroll service or work with a professional to handle it.
Key Considerations Before Electing S-Corp Status
Before you make the switch, it’s worth taking stock of what running an S-Corp really involves. The tax savings can be substantial, but they don’t come without added responsibility.
If you’re not already paying yourself through a payroll system, that needs to change. As an S-Corp owner, you’re considered an employee of your business. That means withholding federal income taxes, Social Security, and Medicare from your paycheck. It also means filing the appropriate payroll tax forms and making regular payments to the IRS. Some business owners choose to run payroll themselves using software. Others hire a payroll provider to take care of it. Either way, it’s a commitment you have to stay on top of.
Then there’s your tax return. With a standard LLC, you might be used to filing a Schedule C with your personal return. Once you’re an S-Corp, that changes. You’ll file a corporate return—Form 1120S—and issue yourself a Schedule K-1 to report your share of the profits. This can increase your accounting costs, since preparing an S-Corp return is more complex than filing as a sole proprietor.
Benefits and Drawbacks
The benefits of electing S-Corp status are real. Lower self-employment taxes, the ability to pay yourself in multiple ways, and a structure that can grow with your business.
But so are the drawbacks. More paperwork. Higher compliance standards. Rules about who can own the company and how stock is structured. S-Corps are limited to 100 shareholders. Everyone must be a U.S. citizen or resident. And the business can only issue one class of stock. If you’re planning to bring on investors or structure ownership creatively, those restrictions might become a roadblock.
The bottom line
Making the S-Corp election is a big decision—and it’s not always clear-cut. If you want help figuring out whether it’s a smart move for your LLC, we’re happy to take a look. Book a consultation and we’ll walk through your current structure, your income, and your goals to see what’s really worth it.
