One of the biggest advantages of forming an LLC is flexibility, especially when it comes to taxes.
By default, an LLC is taxed as a “pass-through” business, meaning profits flow directly to the owner’s personal tax return. But an LLC can choose to be taxed as an S Corporation, and that option is a frequent source of confusion. Many business owners think they must choose between being an LLC or being an S Corp. That is not true. Your business entity would remain an LLC, enjoying the same liability protection and operating flexibility, while you change how the IRS taxes your income.
Self-Employment Tax
Under default rules, all LLC profits are subject to both regular income tax and self-employment tax. For a single-member LLC, profits are reported on the owner’s personal return and treated like sole-proprietor income. For multi-member LLCs, profits pass through to the members like a partnership. In both cases, every dollar of profit faces self-employment tax. This is where S-Corp taxation can make a meaningful difference.
When an LLC elects to be taxed as an S Corporation, the IRS treats the owner as both an employee and an owner. That means the business income is split into two parts. First, the owner must pay themselves a reasonable salary for the work they do. That salary is taxed like normal wages, with income tax and payroll taxes. Any remaining profit can then be paid out as a distribution. Those distributions are still subject to regular income tax, but they are not subject to self-employment tax. The ability to take part of your income as distributions instead of wages is what creates the potential tax savings. This does not make your income tax-free. It simply avoids self-employment tax on the distribution portion which can lead to tax savings.
Reasonable Salary
The idea of a “reasonable salary” is critical. You cannot pay yourself an artificially low wage just to maximize distributions. The IRS expects your salary to reflect what someone in your position would normally earn based on your role, experience, industry, and workload. If the IRS believes your salary is too low, it can reclassify your distributions as wages and assess back taxes, penalties, and interest.
When does the election make sense?
S-Corp taxation tends to make the most sense for established, profitable businesses where the owner is actively working in the business and earning more than they need just to cover living expenses. It is often a good fit for consultants, professionals, and owner-operated service businesses. It is usually not a good fit for new businesses, businesses that are not yet very profitable, or businesses that reinvest all profits back into growth. It also usually offers little benefit for passive real estate LLCs, since rental income is often not subject to self-employment tax anyway.
Electing the S-Corp Status
To elect S-Corp taxation, your LLC files IRS Form 2553. The form must be filed within a strict time window, generally within two months and fifteen days after the start of the tax year you want the election to apply. Late elections are sometimes allowed, but it is far easier to meet the deadline from the start.
Whether the S-Corp Election makes sense for your business
Choosing S-Corp taxation raises additional issues to consider. While it can reduce self-employment taxes, it also adds responsibilities like running payroll and keeping tighter financial records. Before making the election, you should look closely at your profits, determine a realistic salary, and weigh the administrative burden.
A short conversation with a business lawyer or tax advisor can usually tell you whether electing S-Corp status will actually save you money or just add complexity without real benefit. Additionally, there are restrictions that the S-Corp election raises. See our additional blog discussing The Limits of S-Corp Status: What You Need to Know.