The choice between an S-Corporation and an LLC taxed as a sole proprietorship or partnership affects how much self-employment tax you pay, how the QBI deduction applies, and what administrative obligations you take on. The S-Corp strategy saves real money at the right income levels - but it is not always the right answer.
This is the core of the S-Corp vs. LLC comparison. Self-employment tax (SE tax) is 15.3% on the first $184,500 of net self-employment income (2026 Social Security wage base, to be verified against Rev. Proc. 2025-XX) and 2.9% above that. With an LLC taxed as a sole proprietorship or partnership, all net profit is subject to SE tax. IRC §1401.
With an S-Corp, the owner takes a W-2 salary - which is subject to payroll taxes (FICA). Distributions above the salary are not subject to SE tax or FICA. This is the S-Corp tax strategy: pay yourself a reasonable salary, take the rest as distributions, and pay SE/FICA only on the salary.
The IRS requires S-Corp owner-employees to pay themselves a reasonable salary for services performed. There is no bright-line rule, but the IRS has successfully challenged S-Corps that paid zero or token salaries. Factors considered: what similar employees earn, the company's profitability, the owner's duties, and comparable industry wages. The risk is real: If the IRS recharacterizes distributions as wages, it will assess FICA taxes, penalties, and interest. Rev. Rul. 74-44; Watson v. United States (8th Cir. 2012).
| Factor | LLC (SE taxation) | S-Corporation |
|---|---|---|
| SE / FICA tax | All net profit subject to SE tax | Only salary subject to FICA; distributions exempt |
| Payroll requirements | None for single-member LLC | Must run payroll, file 941 quarterly, W-2 annually |
| Administrative complexity | Simple - no payroll, minimal state filings | Higher - payroll, 1120-S return, shareholder basis tracking |
| State filing fees | Generally lower | Many states impose S-Corp fees or minimum taxes |
| QBI deduction (IRC §199A) | Full net profit × 20% (subject to wage/capital limitations) | W-2 wages paid by S-Corp count toward W-2 wage limitation; may increase QBI deduction at high income |
| Retirement plan contributions | Based on SE income calculation | Based on W-2 salary; limits may be lower if salary is set low |
| Health insurance deduction | Above-the-line for SE individuals | W-2 included in salary; deducted above-the-line on 1040 |
| Foreign ownership | LLCs can have foreign owners | S-Corps cannot have nonresident alien shareholders. IRC §1361(b)(1)(C). |
| Number of shareholders | Unlimited | Maximum 100 shareholders. IRC §1361(b)(1)(A). |
| Classes of stock | Multiple classes allowed | Only one class of stock allowed. IRC §1361(b)(1)(D). |
| Break-even point | Better below ~$40,000 net profit | Better above ~$40,000-60,000 net profit (varies) |
The Section 199A qualified business income (QBI) deduction allows pass-through entity owners to deduct up to 20% of qualified business income. OBBBA (P.L. 119-21) made this deduction permanent. For higher-income taxpayers, the deduction is limited by the greater of: (1) 50% of W-2 wages paid by the business, or (2) 25% of W-2 wages plus 2.5% of qualified property. IRC §199A(b)(2).
This creates an interaction with the S-Corp strategy: a sole proprietor LLC with no employees has zero W-2 wages, which limits the QBI deduction at high income levels. An S-Corp that pays the owner a W-2 salary generates W-2 wages - which can increase the QBI deduction ceiling. At high income levels, this can partially offset the cost of payroll taxes on the S-Corp salary.
California imposes a 1.5% state S-Corp tax on net income (minimum $800). New York City taxes S-Corps as general corporations. Massachusetts imposes its own S-Corp excise tax. In these states, the S-Corp SE tax savings may be partially or fully offset by additional state-level entity taxes. Run the full calculation including state costs before electing S-Corp status.
An existing LLC can elect S-Corp status by filing Form 2553 (Election by a Small Business Corporation). The election must be filed by March 15 for the current tax year (or 2.5 months after the start of a new fiscal year). Late elections are available with IRS relief in some circumstances. Rev. Proc. 2013-30 provides automatic relief for late S-Corp elections under certain conditions. IRC §1362.