Choosing the Right Tax Entity for Your Business: LLC vs. S-Corp
Selecting the best legal structure for your business is one of the most critical decisions you’ll make as an owner. The entity you choose not only impacts your liability and management structure but can also have significant tax and financial consequences. Two of the most popular options for small businesses are the Limited Liability Company (LLC) and the S-Corporation (S-Corp). But how do you decide which is right for you—and when might it make sense to switch?
Below, we break down the essentials of both entities, outline key factors to consider, and provide some guidance to help you make an informed choice.
Understanding Your Options
LLC (Limited Liability Company)
An LLC offers flexibility, limited liability protection, and simple management. By default, most single-member LLCs are taxed as sole proprietorships, while multi-member LLCs are taxed as partnerships. Profits and losses “pass through” to your personal tax return, avoiding double taxation.
Key Features:
Simple to set up and maintain
Flexible profit distribution
Minimal compliance requirements
All profits are generally subject to self-employment tax
S-Corporation (S-Corp)
An S-Corp is not a business entity itself, but a tax designation available to eligible LLCs and corporations. With an S-Corp, business profits and losses also flow through to the owners’ personal returns. However, S-Corps have unique tax benefits and stricter compliance rules.
Key Features:
Profits can be split between salary (subject to payroll taxes) and distributions (generally not subject to self-employment tax)
Potential for tax savings, especially as your income grows
Greater IRS scrutiny and more administrative tasks (such as running payroll and filing an extra tax return)
Eligibility requirements (e.g., limited number of shareholders, U.S. residency)
When Should You Consider Switching From an LLC to an S-Corp?
Operating as an LLC may suit your business in the early years, especially when profits are modest. However, as your business income increases, the self-employment taxes on all profits can become significant. This is when the S-Corp election can offer real advantages.
You might consider switching if:
Your business generates consistent profit above what you’d reasonably pay yourself as a salary.
You want to minimize self-employment tax by paying yourself a reasonable salary and taking additional profit as distributions.
You’re comfortable with additional administrative work, such as payroll processing and separate tax filings.
Example Scenario:
Imagine your LLC earns $80,000 in net profit. As a sole proprietor or partnership, you pay self-employment tax on the full amount. If you elect S-Corp status, you could pay yourself a reasonable salary (let’s say $50,000, subject to payroll tax) and take the remaining $30,000 as a distribution, potentially saving several thousand dollars in taxes.
Factors to Weigh Before Making the Switch
Administrative Complexity: S-Corps require more paperwork, payroll setup, and separate tax filings.
Cost: There may be higher accounting and payroll processing costs.
Reasonable Salary: The IRS requires S-Corp owners to pay themselves a market-rate salary—cutting corners here can trigger audits.
State Rules: Some states may have additional rules or taxes for S-Corps.
Steps to Change from LLC to S-Corp Status
Ensure your business meets IRS S-Corp eligibility requirements.
File Form 2553 with the IRS (typically by March 15 for the election to take effect that tax year).
Set up payroll for owner-employees.
Adjust your accounting system for an S-Corp structure.
When Staying an LLC Makes Sense
If your business is just starting out or not yet profitable.
If your profit levels don’t justify the added complexity of S-Corp administration.
If you prefer simplicity with fewer compliance requirements.
Final Takeaway
Choosing your business entity isn’t a one-time decision—it can (and should) change as your business grows. Reassess your structure every year or two to ensure you’re making the most of tax and legal advantages. If you’re unsure of the best path forward, consult with an experienced accounting professional who can tailor advice to your specific situation and goals.
Ready to Review Your Business Structure?
Our firm specializes in guiding small businesses through entity selection and changeovers. Reach out to schedule a consultation, and let’s ensure your business is structured for success as you grow.
