When you start a business, one of the first and most critical decisions you’ll make is choosing a legal structure. This choice impacts everything from your personal liability to how much you pay in taxes. For many small business owners, the decision boils down to two popular options: the Limited Liability Company (LLC) and the S Corporation (S Corp).
But what’s the real difference? While they sound similar and offer some of the same benefits, how they are treated for tax purposes is fundamentally different. Choosing the right one can save you thousands of dollars a year, while choosing the wrong one can lead to administrative headaches and a higher tax bill.
Let’s break down the alphabet soup to help you make an informed decision.
What is an LLC? The Shield of Flexibility
Think of an LLC as a foundational business structure. It’s an entity you form at the state level. The primary reason business owners form an LLC is right in the name: limited liability. It creates a legal shield between your personal assets (your home, car, personal savings) and your business debts and lawsuits. If the business gets sued, your personal assets are generally protected.
How LLCs are Taxed by Default:
By default, the IRS treats an LLC as a “pass-through” entity. This means the business itself doesn’t pay taxes. Instead, the profits and losses “pass through” to the owner’s personal tax return.
- Single-Owner LLC: Taxed like a sole proprietorship.
- Multi-Owner LLC: Taxed like a partnership.
In both cases, all the net profit is subject to two types of tax: income tax and self-employment tax (currently 15.3% for Social Security and Medicare). This self-employment tax is the crucial part to remember.
What is an S Corp? A Strategic Tax Choice
Here’s the most important thing to understand: An S Corp is not a business entity. You cannot go to the state and “form” an S Corp. An S Corp is a tax election.
A business must first be structured as an LLC or a C Corporation. Then, it can file a form with the IRS to elect to be taxed as an S Corp. While both offer limited liability protection, the S Corp election changes the game on how the owner is taxed.
How S Corps are Taxed:
An S Corp is also a pass-through entity, but with a key difference in how owner compensation is handled. It allows you to split your earnings into two categories:
- A Reasonable Salary: As the owner, you must be paid a “reasonable salary” for the work you do. This salary is treated as employee wages and is subject to FICA taxes (the employee/employer version of self-employment taxes).
- Distributions: Any remaining profits in the business can be paid out to you as a distribution. This portion of your income is not subject to self-employment/FICA taxes.
This is the main appeal of the S Corp: potential tax savings.
The Real-World Difference: A Simple Example
Let’s say your business made $100,000 in net profit this year.
- As a standard LLC: The entire $100,000 is subject to both income tax AND the 15.3% self-employment tax.
- Self-Employment Tax owed: $100,000 x 15.3% = $15,300
- As an LLC taxed as an S Corp: You determine a reasonable salary for your role is $60,000. The remaining $40,000 can be taken as a distribution.
- The $60,000 salary is subject to FICA taxes (roughly $9,180, split between you and the business).
- The $40,000 distribution is subject to income tax, but NOT FICA/self-employment tax.
- Potential Tax Savings: You avoided the 15.3% tax on the $40,000 distribution, saving approximately $6,120.
Key Considerations and Trade-Offs
While the tax savings are attractive, an S Corp comes with more complexity.
| Feature | LLC (Default Taxation) | S Corp (Tax Election) |
| Formation | Simple state filing | Must first form an LLC/C Corp, then file an election with the IRS |
| Liability Protection | Yes | Yes |
| Taxation | All profits subject to self-employment tax | Only “reasonable salary” is subject to FICA tax |
| Payroll | Not required for owner | Owner must be on formal payroll, with taxes withheld |
| Complexity | Low administrative burden | Higher administrative burden (payroll, potential for extra tax forms) |
So, Which Structure is Right for You?
- Stick with a standard LLC if: You’re just starting out, your profits are still relatively low (e.g., under $50,000), or you value maximum simplicity. The costs and administrative hassle of an S Corp may outweigh the tax benefits at this stage.
- Consider an S Corp election if: Your business is consistently profitable and you can afford to pay yourself a reasonable salary. Once your profits significantly exceed that salary, the potential for tax savings becomes very real and often justifies the added complexity.
Choosing your tax structure is a foundational decision that can have lasting financial consequences. While this guide provides a starting point, the “right” choice depends entirely on your specific circumstances, profitability, and future goals.
At Kohani & Associates, we help business owners navigate these crucial decisions every day. We can analyze your financial situation, project your tax liability under different structures, and help you choose the path that best aligns with your business goals. If you’re ready to ensure your business is structured for maximum tax efficiency, contact us for a consultation.