S Corporation vs LLC: The Tax Differences
An LLC is a legal form and an S corporation is a tax election — how each is taxed, and when an LLC should elect
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
An LLC and an S corporation are not alternatives — they answer different questions. An LLC is a legal entity created under state law that provides liability protection; an S corporation is a federal tax election available to a corporation or an LLC. Most small businesses are LLCs; the question is whether to keep default taxation or elect S treatment.
On this page
Two questions, not one
Question one is legal: what entity holds the business? A sole proprietorship (no entity), an LLC, or a corporation — decided by liability protection, state fees, and formalities. Question two is tax: how is that entity taxed? A single-member LLC defaults to a disregarded entity (Schedule C), a multi-member LLC to a partnership (Form 1065), and a corporation to a C corporation (Form 1120) — and any of them may elect S corporation status on Form 2553 (the Form 2553 guide). "S corp vs LLC" is really "LLC with the default taxation vs LLC with the S election," and the LLC is the entity in both.
The side-by-side
| LLC — default taxation | LLC or corporation — S election | |
|---|---|---|
| Legal form | LLC | LLC (or corporation) — unchanged |
| Federal return | Schedule C (one member) or Form 1065 (several) | Form 1120-S with K-1s |
| Owner's payroll tax | Self-employment tax on 92.35 percent of net profit — 15.3 percent up to the Social Security wage base, 2.9 percent above (partners on their shares) | Payroll tax on the owner's reasonable salary only; distributions above salary are free of it |
| Owner compensation | Draws — no payroll, no W-2 | Reasonable salary through payroll (W-2, quarterly 941s, state payroll) plus distributions |
| QBI deduction base | All net profit | Net profit after the salary (salary is excluded; it also supplies W-2 wages for the limitation above the threshold) |
| Ownership flexibility | Any number and type of members; special allocations; preferred returns | 100 shareholders maximum; individuals, certain trusts, estates, and certain exempt organizations only; one class of stock — distributions strictly by ownership |
| Losses | Pass through to members, subject to basis (including the LLC's debt), at-risk, and passive rules | Pass through to shareholders, subject to stock-and-debt basis (entity-level debt gives no basis), at-risk, and passive rules |
| Health insurance | Above-the-line deduction for the owner | Premiums run through the W-2 as wages, then deducted above the line |
| Retirement plan base | Net profit (20 percent for SEP or Solo 401(k) employer contribution) | W-2 salary (25 percent) — a low salary limits the room |
| Home office | Form 8829 on Schedule C | Accountable-plan reimbursement from the corporation |
| Family employees | Children under 18 exempt from Social Security and Medicare (sole proprietorship or parents-only partnership) | No exemption |
| State treatment | Franchise or LLC fees in some states | Some states tax S corporations at the entity level or don't recognize the election |
| Cost | Lowest — one return, no payroll for the owner | Higher — the 1120-S, a payroll system, basis tracking, possibly a state S corporation layer |
When does the S election pay?
When the payroll tax saved on distributions exceeds the election's costs plus the QBI deduction lost on the salary. The saving is roughly 15.3 percent of the distribution portion up to the Social Security wage base and 2.9 percent above it (3.8 percent once the Additional Medicare Tax threshold is crossed); the costs are the corporate return, a payroll for the owner (small if the business already runs payroll for employees; a new fixed cost if not), the state layer, and the QBI deduction lost on the salary (20 percent of it) below the threshold. The crossover for most owner-operated businesses lands between US$60,000 and US$120,000 of net profit, depending on the trade and the defensible salary — lower where a crew payroll already exists, higher for solo professionals whose reasonable salary is most of the profit. The entity guides on this site run the worksheet trade by trade.
What is reasonable compensation?
The IRS requires an S corporation to pay a shareholder who works in the business a salary comparable to what an employee would earn for the same services before taking distributions. Set it from market data for the owner's role (a master electrician, a service manager, an employed consultant of the same seniority), document the comparison, and revisit it annually. A salary set at a fraction of the profit to maximize distributions is the audit issue that turns the S election's saving into an assessment of back payroll taxes plus penalties — and the reason the election is worth less for personal-service businesses, whose reasonable salary is nearly all the profit.
What does the S election give up?
Flexibility. An LLC taxed as a partnership can allocate profits unequally, pay guaranteed payments by production, admit a corporate or foreign investor, and give members basis in the entity's debt for deducting losses. An S corporation must distribute strictly by ownership (the single-class-of-stock rule), can admit only eligible shareholders, and gives shareholders basis only in their own investment and direct loans — the reason multi-partner firms with unequal producers and equipment-heavy businesses in their loss years often stay partnerships (the countertop entity guide).
Worked example
Two owners of the same kind of business — a landscaping company netting US$150,000 with six seasonal employees on payroll. Owner A keeps the LLC's default treatment: US$150,000 of Schedule C profit, self-employment tax about US$21,200, the full QBI deduction on US$150,000 less the SE adjustment. Owner B elects S status with a US$70,000 operations-manager salary: payroll tax on US$70,000 about US$10,700, distributions of US$80,000 free of payroll tax — saving about US$10,500 — against the 1120-S (US$1,500), the incremental payroll cost (US$300, since the crew's payroll exists), the state's S corporation fee, and US$14,000 of QBI deduction lost (worth about US$3,000 at her bracket). Net: roughly US$5,000 to US$6,000 a year in B's favor. A solo consultant netting the same US$150,000 with a US$125,000 reasonable salary and no existing payroll: US$25,000 of distributions saving only about US$2,100 (self-employment tax on the full profit less payroll tax on the salary), against a new payroll, the return, and about US$25,000 of QBI deduction lost — the election loses.
Frequently asked questions
Is an S corporation an LLC?
No — they are different kinds of thing. An LLC is a legal entity; an S corporation is a tax classification. An LLC can elect to be taxed as an S corporation and remain an LLC under state law.
Which pays less tax, an LLC or an S corporation?
An LLC with the S election pays less payroll tax once profit exceeds a reasonable salary by enough to cover the election's costs — typically above US$60,000 to US$120,000 of net profit. Below that, the default LLC taxation is cheaper.
Can an LLC be taxed as an S corporation?
Yes — by filing Form 2553, which for an LLC also serves as the corporate classification election. The LLC's legal form does not change.
What is reasonable compensation?
The salary an S corporation must pay a working shareholder before distributions, comparable to what an employee would earn for the same services, supported by market data and revisited annually.
Official sources
The IRS states: “Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”).” — Internal Revenue Service, Limited liability company (LLC), https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc
The IRS states: “S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.” — Internal Revenue Service, S corporations, https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations
Next step
Fairlight Accounting is a cross-border accounting and tax practice with a U.S. Tax Desk and a Canadian Tax Desk. Our U.S. Tax Desk handles entity and election analysis with reasonable-compensation documentation, S election worksheets by trade, and the partnership-versus-S corporation decision for multi-owner businesses. See pricing or book a call.
Cross-border taxes, handled in one place
U.S. and Canadian filings prepared together by our U.S. and Canadian Tax Desks.
Book a free fit call