If you operate a single-member LLC or multi-member LLC taxed as a partnership, you may be familiar with self-employment taxes eating into your bottom line. Electing S Corporation (S Corp) status can offer real tax savings—especially for profitable businesses—by reducing exposure to self-employment tax. However, the benefits come with compliance responsibilities that are important to weigh.
Let’s look at a simplified example: If an LLC owner earns $100,000 in net income and is taxed as a sole proprietor, the entire amount is subject to self-employment tax at 15.3%, resulting in a tax of approximately $14,130. By contrast, if that LLC elects to be taxed as an S Corporation and pays the owner a “reasonable salary” of $50,000, only that amount is subject to payroll taxes—about $7,650. The remaining $50,000 can be taken as a distribution, free from self-employment tax. The result? A potential savings of $6,480 on self-employment taxes alone.
However, these savings come with trade-offs. S Corporations must file a separate corporate tax return (Form 1120-S), issue W-2s to employee-shareholders, and make quarterly payroll filings (Forms 941, 940, and state equivalents). Owners must also determine and document a “reasonable” salary and stay compliant with IRS scrutiny on compensation and distributions. In addition, S Corps have stricter rules regarding shareholder eligibility and stock classes, and cannot retain earnings in the same manner as a sole proprietorship or partnership.
Key Takeaways:
- Tax Savings Potential:
- $100,000 income taxed as sole proprietor = $14,130 in self-employment tax.
- Same income taxed as S Corp with $50,000 salary = $7,650 payroll tax.
- Net tax savings = $6,480.
- Self-Employed LLC:
- All net income subject to 15.3% self-employment tax.
- Simpler tax filing (included on Schedule C).
- QBI deduction available but subject to limits.
- S Corporation-Elected LLC:
- Only salary subject to payroll taxes.
- Owner must take “reasonable compensation.”
- Distributions generally not subject to employment tax.
- Potentially greater QBI deduction due to wage limitations.
- Must file Form 1120-S, run payroll, and comply with IRS requirements.
- Higher bookkeeping and administrative overhead.
Electing S Corporation status can be a valuable strategy, especially as income grows—but it isn’t one-size-fits-all. Business owners should schedule an advising session with a tax professional to evaluate whether an S Corp election is appropriate for their specific income level, industry, and long-term goals. A tailored analysis can help avoid compliance pitfalls and ensure the tax benefits outweigh the costs.