LLC vs S-Corp Taxes: When the S Election Actually Saves Money

This is the mix-up that causes most of the confusion: an LLC is a legal structure created under state law. An S corporation is a federal tax election made with the IRS on Form 2553. They sit on different layers, and an LLC can make the S election.

Without any election, a single-member LLC is a disregarded entity for federal tax purposes, taxed exactly like a sole proprietorship on Schedule C. A multi-member LLC defaults to partnership taxation and files Form 1065. In both cases, every dollar of net profit flows to the owner's personal return and is subject to self-employment tax, whether the owner takes the cash out of the business or leaves it in the bank.

An LLC (or a C corporation) can instead file Form 2553 and ask the IRS to tax it as an S corporation. Nothing changes about the state-level entity. What changes is how the owner's profit gets taxed and reported: part of it as W-2 wages to the owner as an employee, part of it as a shareholder distribution. That split is the entire mechanism behind any tax savings, and it only matters once you understand the tax it's designed to reduce: self-employment tax.

Self-employment tax is 15.3% total: 12.4% for Social Security and 2.9% for Medicare, per the IRS. It applies to 92.35% of your net profit, not the full amount, because the calculation backs out the employer-equivalent half before applying the rate.

The 12.4% Social Security piece only applies up to the Social Security wage base, which is $184,500 for earnings in 2026, per IRS guidance. Above that ceiling, only the 2.9% Medicare piece continues, plus an additional 0.9% Medicare tax once combined wages and self-employment income cross $200,000 for a single filer or $250,000 for a married couple filing jointly, per the IRS.

Half of self-employment tax is deductible as an adjustment to income, which softens the blow a little but doesn't change the underlying math: on a default LLC, every dollar of profit up to the wage base effectively carries a 15.3% payroll-style tax on top of ordinary income tax, regardless of whether the owner pays themselves a salary, takes a draw, or leaves the cash in the business checking account. That's the cost an S election is trying to reduce, not eliminate.

Once an LLC elects S-corp status, the owner who works in the business becomes a W-2 employee of it. The corporation runs payroll, withholds income tax and the employee's half of FICA, and pays the employer's half of FICA, exactly like it would for any other employee. That salary is subject to the same 15.3% (split 7.65% employer, 7.65% employee) as self-employment tax, just collected through payroll instead.

The difference shows up on the rest of the profit. After paying the salary and the business's other expenses, whatever is left can be paid out to the owner as a shareholder distribution. A distribution is not wages. It carries no Social Security tax, no Medicare tax, and no additional 0.9% Medicare tax, no matter how large it is. It's still subject to ordinary federal and state income tax, same as it would have been on a default LLC.

So the entire savings comes from moving profit out of the 15.3%-taxed bucket (salary, or SE income on a default LLC) and into the 0%-payroll-tax bucket (distributions). Nothing here reduces income tax. A dollar of distribution and a dollar of self-employment income are taxed the same way for federal and state income tax purposes; the only tax that goes away is Social Security and Medicare.

The IRS requires an S-corp shareholder who works in the business to be paid reasonable compensation for that work before any distribution goes out, per IRS guidance on S corporation compensation. There's no fixed formula or safe-harbor number. Examiners look at what the shareholder actually did (their training, experience, time and duties), what comparable jobs pay in the same market, what non-shareholder employees are paid for similar work, the corporation's dividend history, and whether the pay was set by a formal agreement rather than picked to minimize tax.

Setting the salary too low and the distribution too high is the most common way an S election gets unwound. If the IRS successfully reclassifies distributions as wages, the business owes the back payroll tax on that amount, plus penalties and interest, and the owner is back to paying close to what they would have paid as a default LLC, minus the professional fees already spent setting up the S-corp payroll and filing.

A workable approach: price the role the way you'd price it to hire someone else to do it, using actual market data (industry salary surveys, job postings for comparable roles, or a documented benchmarking exercise), and keep that documentation on file. This is a facts-and-circumstances judgment, not a percentage you can apply blindly, and it should be revisited any time the business's profit or the owner's role changes materially.

An S election isn't free to run. Once it's in place, the business needs a real payroll system (state unemployment tax registration, federal and state withholding, quarterly Form 941 filings, an annual Form 940, and a W-2 at year-end), on top of whatever it was already doing as a default LLC.

The entity also files a separate federal return, Form 1120-S, due March 16, 2026 for the 2025 tax year on a calendar-year entity, per the IRS, plus a Schedule K-1 issued to the owner each year. That's an additional return beyond the personal Form 1040 the owner was already filing, and most preparers price it separately.

Add payroll processing fees, a bookkeeping cleanup to separate salary from distributions correctly, and in some states an extra state-level filing or fee (more on that next), and the realistic added cost of running an S-corp is commonly a few thousand dollars a year in extra compliance work. That cost has to come out of the self-employment tax savings before you know whether the S election was worth making, which is why it rarely pencils out at low profit levels.

Take a single-member LLC with $120,000 in net profit for the year, no other complications, filing as a default disregarded entity.

As a default LLC (self-employment tax):

• Net earnings from self-employment: 92.35% x $120,000 = $110,820
• Social Security portion: 12.4% x $110,820 = $13,741.68 (the full amount is under the $184,500 wage base)
• Medicare portion: 2.9% x $110,820 = $3,213.78
• Total self-employment tax: about $16,955

As an S corporation, with a $70,000 salary and $50,000 distribution:

• FICA on the $70,000 salary: 15.3% x $70,000 = $10,710 (split $5,355 employer, $5,355 employee)
• FICA on the $50,000 distribution: $0
• Total payroll tax: $10,710

On paper, that's roughly $6,245 in Social Security and Medicare tax avoided in the first year. Subtract the added payroll and filing costs from running the S-corp (commonly a few thousand dollars a year, as covered above), and the real, net-of-cost savings in this example is smaller than the headline number, though usually still positive at this profit level. The salary chosen here still has to meet the reasonable-compensation test for whatever work this owner actually does; this example doesn't establish that $70,000 is reasonable for any particular business, only shows the mechanics.

A federal-only comparison misses real money in several states. Three examples that come up often:

California taxes S corporation net income at the entity level (California's rate has held at 1.5% of net income with an $800 minimum franchise tax; confirm the current figure with the Franchise Tax Board before filing, since California does adjust rules from time to time). That's a tax a default single-member LLC taxed as a sole proprietorship doesn't pay in the same way, so the state-level cost has to be weighed against the federal self-employment tax savings, not ignored.

New York does not treat a federal S-corp election as automatic at the state level. The corporation has to file its own separate election, Form CT-6, to be treated as a New York S corporation, per the New York State Department of Taxation and Finance. Skip that filing and the entity can end up taxed as a C corporation for state purposes while still filing as an S corporation federally, which is a mismatch worth catching before it happens, not after.

Illinois imposes a Personal Property Replacement Tax of 1.5% of net income on S corporations and partnerships, on top of the regular Illinois income tax, per the Illinois Department of Revenue. It's a flat add-on that a default LLC filing as a sole proprietorship doesn't face in the same form.

Every state runs this differently. Before electing, get the actual state-level rule for your state, not just the federal math.

The S election is a tool for a specific problem: high self-employment tax on a profitable, actively-run business. It doesn't fit every situation.

At low profit, the added payroll and filing costs can eat most or all of the self-employment tax savings; there's no fixed profit floor because it depends on your state and your payroll costs, but a business clearing well under $40,000 in profit a year is unlikely to come out ahead once the extra compliance cost is counted.

A business planning to reinvest most of its profit rather than pay it out doesn't gain much either. Self-employment tax and the S-corp equivalent both apply based on what the entity earns and how it's characterized, not strictly on what's withdrawn in cash, so "leaving the money in the business" doesn't sidestep the comparison the way it might for income tax planning.

A multi-member LLC where owners contribute unequal amounts of capital versus labor, or want flexible, non-pro-rata distributions, can also run into trouble: an S corporation has stricter rules on ownership structure and a single class of stock, and the reasonable-compensation test has to be applied separately to every shareholder-employee, which adds complexity fast with more than one owner active in the business.

Form 2553 has to be filed no more than 2 months and 15 days after the start of the tax year the election is meant to cover, per the IRS; for a calendar-year entity that's March 16, 2026 for the 2026 tax year. Miss that window and the election generally doesn't take effect until the following year, though the IRS does have late-election relief procedures for a reasonable-cause showing, which a preparer can walk through case by case rather than assuming it's automatically lost.

A new LLC electing S-corp status for its first year has more flexibility: the deadline runs from the date the entity comes into existence or starts doing business, not the calendar year, so a mid-year start doesn't automatically mean waiting until the following January.

Because payroll has to be running correctly from the effective date forward (the salary/distribution split doesn't work retroactively in any clean way once the year is partly over), it's worth treating the election date and the first payroll run as one decision, not two separate ones made months apart.

Written out as rows rather than a grid:

• Federal income tax on profit: Same either way. The S election doesn't change this.
• Social Security and Medicare tax: Default LLC pays 15.3% self-employment tax on nearly all profit up to the wage base. S-corp pays 15.3% FICA only on the salary portion; the distribution portion pays none.
• Payroll required: Default LLC, no. S-corp, yes, on the owner's own salary, with all the usual withholding and filing that comes with running payroll for any employee.
• Federal returns filed: Default LLC (single-member), just the owner's Form 1040 with Schedule C. S-corp, a separate Form 1120-S plus a Schedule K-1, in addition to the owner's Form 1040.
• Audit exposure on owner pay: Default LLC, low; there's no salary to challenge. S-corp, real; the IRS can and does challenge an unreasonably low salary.
• State-level treatment: Default LLC, generally follows the federal default. S-corp, varies by state; some states add their own election, tax, or both, as covered above.
• Best fit: Default LLC suits lower profit, simpler operations, or a business reinvesting most of its earnings. S-corp suits a profitable, actively-run business where the owner can support a market-rate salary and still have meaningful profit left over as a distribution.