Electing S corp status can offer significant tax advantages and operational benefits for businesses, often making it a preferred choice over an LLC's default tax treatment, especially as a business grows and becomes profitable. While an LLC provides liability protection and flexibility, "S corp" primarily refers to a tax designation that an LLC can actually elect to adopt. This distinction is crucial for understanding why S corp status can be "better."
Understanding the Comparison: S Corp vs. LLC Default Taxation
An LLC (Limited Liability Company) is a legal business structure that provides liability protection to its owners, shielding their personal assets from business debts and lawsuits. By default, an LLC is taxed as a pass-through entity:
- A single-member LLC is taxed as a sole proprietorship.
- A multi-member LLC is taxed as a partnership.
In both default scenarios, business profits and losses are reported on the owners' personal tax returns, and the business itself doesn't pay corporate income tax.
An S corp, on the other hand, is a tax election made with the IRS (Internal Revenue Service). It is not a separate legal entity like an LLC or a C corp. An S corp can be a corporation or an LLC that has elected S corp tax status. The primary reason businesses elect S corp status is for specific tax benefits.
Key Advantages of S Corp Election
The "better" aspect of S corp status primarily stems from its unique tax treatment, offering two significant advantages:
1. Avoiding Double Taxation and Pass-Through Benefits
One of the most compelling reasons for S corp election is its ability to bypass corporate-level taxation, thereby avoiding double taxation.
- In an S corp, the company's income and deductions pass directly through to the shareholders' personal tax returns.
- The company itself does not pay federal income tax.
- This means that the shareholders of the S corp are only taxed once on the company's profits—on their individual tax returns—rather than twice, as a company (corporate tax) and again as shareholders (when profits are distributed as dividends), which is typically the case for C corporations.
While an LLC taxed as a sole proprietorship or partnership also offers pass-through taxation, the S corp offers an additional layer of potential tax savings, particularly concerning self-employment taxes.
2. Potential for Self-Employment Tax Savings
This is often the most significant financial benefit for profitable businesses with S corp status. For an LLC taxed as a sole proprietorship or partnership, all business profits passed through to the owner(s) are subject to self-employment taxes (Social Security and Medicare taxes, currently 15.3% on net earnings up to a certain threshold for Social Security, and 2.9% for Medicare on all net earnings).
However, with an S corp election, owners who also work for the business can split their compensation into two parts:
- A "reasonable salary": This portion is subject to regular payroll taxes (including Social Security and Medicare) and income tax withholding, just like any employee's wages.
- Distributions (dividends): Any remaining profits after paying the reasonable salary can be taken as distributions. These distributions are not subject to self-employment taxes. They are only taxed at the owner's individual income tax rate.
Example:
Imagine a business owner makes $100,000 in profit.
- As an LLC (default taxation): The entire $100,000 is subject to self-employment tax (approx. 15.3%).
- As an LLC electing S corp status: The owner might pay themselves a "reasonable salary" of $60,000. This $60,000 is subject to payroll taxes. The remaining $40,000 can be taken as a distribution, which is not subject to self-employment tax, leading to substantial savings.
How S Corp Status Works in Practice
- Owner as Employee: Owners of an S corp who actively work in the business are generally required to be paid a "reasonable salary." The IRS defines "reasonable" based on what comparable companies pay for similar services.
- Payroll Requirements: An S corp must run payroll, withhold taxes, and file regular payroll tax returns (e.g., Form 941). This adds administrative complexity compared to a default LLC.
- Shareholder Limitations: S corps have restrictions on the number and type of shareholders (e.g., generally limited to 100 shareholders, all must be U.S. citizens or residents, and only one class of stock).
Comparing LLC (Default) vs. S Corp (Tax Election)
| Feature | LLC (Default Tax) | S Corp (Tax Election for LLC or Corp) |
|---|---|---|
| Legal Structure | Legal entity with liability protection | Tax designation; requires an underlying entity |
| Liability Protection | Yes, for owners' personal assets | Yes, inherited from the underlying entity |
| Taxation of Profits | Pass-through: All profits subject to income tax and self-employment tax for active owners. | Pass-through: Profits split into reasonable salary (subject to payroll taxes) and distributions (not subject to self-employment tax). |
| Self-Employment Tax | Applies to all net earnings | Applies only to reasonable salary portion |
| Administrative Burden | Lower (no payroll for owners) | Higher (payroll, specific S corp tax forms) |
| Owner Compensation | Draws/distributions; all taxed | Salary + distributions |
| Complexity | Simpler to set up and maintain | More complex, requires strict IRS compliance |
When S Corp Status is Advantageous
Choosing S corp status often becomes advantageous when:
- Your business is consistently profitable.
- Your profits exceed what you consider a "reasonable salary" for your services.
- The potential self-employment tax savings outweigh the increased administrative costs (payroll, tax preparation).
- You are comfortable with the added payroll and tax compliance requirements.
In summary, while an LLC provides foundational legal protection and flexibility, electing S corp tax status can offer significant tax savings, particularly by reducing the self-employment tax burden on profits distributed beyond a reasonable salary. This makes it a strategically "better" choice for many growing and profitable businesses.
