The LLC vs S-Corp question comes up the moment a business starts making real money. Every entrepreneur hears the same advice: "You should switch to an S-Corp to save on taxes." The advice is often right — but not always, and the details matter more than the headline.
First, a clarification: an S-Corp isn't a separate entity type. It's a tax election. You can form an LLC and then elect to be taxed as an S-Corp with the IRS (Form 2553). The LLC stays your legal entity; the tax treatment changes. This is important because it means you're not choosing between LLC and S-Corp — you're choosing between default LLC taxation and S-Corp tax election.
The Self-Employment Tax Problem
Under default LLC taxation, all business profit flows to your personal return and is subject to self-employment tax of 15.3% (12.4% Social Security plus 2.9% Medicare) on top of regular income tax. If your business earns $120,000 in profit, you owe roughly $17,000 in self-employment tax alone — before income tax even enters the picture.
With an S-Corp election, you split that $120,000 into two buckets: a reasonable salary (say $60,000) that's subject to payroll tax, and a distribution ($60,000) that is not subject to self-employment or payroll tax. You still pay income tax on the full amount, but you avoid the 15.3% SE tax on the distribution portion. On $60,000 in distributions, that's roughly $9,180 in savings.
The "Reasonable Salary" Catch
The IRS requires S-Corp owners to pay themselves a "reasonable salary" — compensation that's comparable to what you'd pay someone else to do your job. You can't pay yourself a $10,000 salary on $200,000 in profit and call the rest distributions. The IRS has successfully challenged unreasonably low salaries, and the penalties include reclassifying distributions as wages plus penalties and interest.
A common guideline is setting salary at 40-60% of profit, depending on your industry and role. A software consultant earning $150,000 might set a reasonable salary of $80,000-$90,000. A retail business owner earning $80,000 might set it at $45,000-$55,000. When in doubt, err on the side of a higher salary — the tax savings aren't worth an audit.
When S-Corp Doesn't Make Sense
S-Corp comes with costs that LLC doesn't: mandatory payroll processing ($500-$1,500/year), additional tax return preparation ($1,000-$2,500/year), and potentially more complex bookkeeping. These costs typically run $2,000-$5,000 annually. If your business profit is below $50,000-$60,000, the self-employment tax savings often don't exceed these additional costs.
The general rule of thumb: S-Corp starts making sense when business profit consistently exceeds $60,000-$80,000 per year. Below that, the administrative costs eat the tax savings. Above that, the savings grow proportionally and can reach $10,000-$20,000 annually at higher income levels. This is a tax professional conversation, not a tax software decision — your specific situation matters.
If you want to see the exact comparison for your income level, our free LLC vs S-Corp Tax Calculator calculates both scenarios side by side — self-employment tax, income tax, QBI deduction, and the net difference — so you can see the actual dollar savings before talking to your CPA.