If you’re starting a business—or already running one as a sole proprietor—choosing the right legal structure is one of the most important financial decisions you’ll make. Two of the most popular options are the Limited Liability Company (LLC) and the S Corporation (S Corp). Both offer liability protection and tax advantages, but they differ significantly in how income is taxed and reported.
So, which one is better for tax purposes—an S Corporation or an LLC? The answer depends on your business size, income level, reinvestment plans, and how you want to pay yourself.
In this post, we’ll break down the key tax differences between LLCs and S Corps, their pros and cons, and how to choose the best fit for your business.
Understanding the Basics
✅ What is an LLC?
An LLC is a legal entity formed at the state level that provides liability protection for its owners (called “members”) and offers flexible tax options.
✅ What is an S Corporation?
An S Corporation is not a type of entity but rather a tax election made with the IRS. It allows corporations or eligible LLCs to be taxed under Subchapter S of the Internal Revenue Code, enabling pass-through taxation while reducing self-employment taxes.
How an LLC is Taxed
By default, the IRS taxes LLCs as pass-through entities:
Single-member LLCs are taxed like sole proprietorships.
Multi-member LLCs are taxed like partnerships.
In both cases:
Business income is reported on the owner’s personal tax return.
Profits are subject to self-employment tax (15.3%) plus income tax.
LLCs can elect to be taxed as S Corps or C Corps by filing Form 8832 or 2553.
How an S Corporation is Taxed
An S Corp is a pass-through entity, meaning:
Income passes through to shareholders (owners) and is taxed at their individual income tax rates.
The key tax advantage: owners can receive part of the income as salary and part as distributions.
Salary is subject to payroll taxes.
Distributions are not subject to self-employment tax.
However:
S Corps must file Form 1120-S annually.
Owners must be paid a reasonable salary.
You must run formal payroll and keep corporate records.
Key Tax Differences: LLC vs. S Corp
| Feature | LLC (Default) | S Corporation |
|---|---|---|
| Taxation Type | Pass-through (Schedule C or 1065) | Pass-through (Form 1120-S + Schedule K-1) |
| Self-Employment Tax | Paid on 100% of net income | Only on salary (not on distributions) |
| Payroll Required | No | Yes |
| Tax Filing Complexity | Simple (single return) | More complex (corporate + personal filings) |
| Salary Requirement | Not required | Must pay reasonable salary |
| Owner Draws | Allowed without payroll | Must run payroll for compensation |
| Tax Election Flexibility | Can choose S Corp taxation | Must meet IRS qualifications |
| IRS Scrutiny | Low | Higher, especially for low salary owners |
Scenario: Tax Savings Comparison
Let’s say your business earns $100,000 in net income.
As an LLC (default taxation):
100% of income is subject to self-employment tax (15.3%)
$100,000 × 15.3% = $15,300
Then you also pay federal income tax (based on your bracket)
As an S Corporation:
You pay yourself a reasonable salary: $50,000
Subject to payroll taxes = $50,000 × 15.3% = $7,650
The remaining $50,000 is taken as distribution (not subject to SE tax)
Tax savings on SE tax: $15,300 – $7,650 = $7,650
Result: S Corps can significantly reduce self-employment taxes—but only if structured and managed properly.
Pros and Cons of an LLC
✅ Pros:
Simple setup and maintenance
Flexible taxation (can elect S Corp or C Corp taxation)
Fewer compliance requirements than corporations
Owner draw (no payroll required)
❌ Cons:
100% of profits subject to self-employment tax
May pay more in taxes as income grows
No tax savings from salary/distribution split
Pros and Cons of an S Corporation
✅ Pros:
Significant savings on self-employment taxes
Pass-through taxation (avoids double taxation)
Can offer fringe benefits like retirement contributions
❌ Cons:
Requires payroll and corporate compliance
Reasonable compensation rules apply
Limited to 100 shareholders (all must be U.S. citizens/residents)
Only one class of stock allowed
When Should You Switch to S Corp Taxation?
While an LLC is great when starting out, switching to an S Corp can offer significant tax savings once your income reaches a certain threshold.
General Rule of Thumb:
If your net business income exceeds $50,000–$70,000 per year, it may be time to consider electing S Corp status.
That said, the decision should depend on:
Your actual profits
Your ability to run payroll
Willingness to take on more administrative work
State-specific tax treatment of S Corps
Can an LLC Become an S Corporation?
Yes. You can keep your LLC legal structure and elect to be taxed as an S Corp by:
Filing Form 2553 with the IRS
Setting up payroll for yourself and any employees
Paying a reasonable salary and taking distributions
This gives you the best of both worlds: LLC legal simplicity with S Corp tax efficiency.
State Tax Considerations
While federal rules are generally consistent, state taxation can vary:
Some states do not recognize S Corps and treat them like C Corps
Others impose franchise taxes or minimum fees on S Corps or LLCs
Be sure to consult with a local tax advisor
Final Thoughts: Which is Better for Tax Purposes?
If you’re a solo entrepreneur or freelancer just starting out, an LLC taxed as a sole proprietorship may be the simplest and most cost-effective solution.
As your income grows, however, switching to an S Corporation can help you save thousands each year in self-employment taxes—if you’re willing to take on the extra administrative duties like payroll, compliance, and formal reporting.
🚀 Not sure which structure fits your goals?
At Tax Alternatives, we help business owners analyze their income, structure, and long-term plans to choose the most tax-efficient setup.
📩 Fill out the form below to schedule a consultation and find out whether an LLC or an S Corp is right for your business.
