LLC or S Corporation: When the Election Pays Off
One of the most common questions from growing businesses is whether to become an S corporation. The usual reason is self-employment tax. The usual mistake is electing too early, or for the wrong reasons.
An LLC and an S corporation are not really opposites. An LLC is a legal entity formed under state law. S corporation status is a federal tax election. Many businesses are LLCs that have elected to be taxed as S corporations.
How an LLC is taxed by default
A single-member LLC is taxed like a sole proprietorship, and an LLC with two or more members is taxed as a partnership. Either way, the profit flows to the owners' personal returns. Owners who work in the business generally pay self-employment tax on their share of the profit: 15.3 percent on earnings up to the Social Security wage base, which is $184,500 for 2026, and 2.9 percent above it. An additional 0.9 percent Medicare tax applies to earnings over $200,000, or $250,000 for married couples filing jointly.
What the S election changes
An S corporation owner who works in the business is an employee. The company has to pay that owner a reasonable salary for the work, and the salary carries payroll taxes. Profit above the salary passes through to the owner without payroll or self-employment tax.
That is where the savings come from. Say a business earns $200,000 and pays its owner a reasonable salary of $100,000. Payroll taxes apply to the $100,000 salary instead of to nearly all of the $200,000 profit. In that example, federal payroll and self-employment taxes drop by roughly $13,000. The net savings are smaller once you account for the added costs and the changes to other deductions, but they can still be meaningful.
What counts as a reasonable salary depends on the work you do and what it would cost to hire someone to do it. It is not a number to pick for tax savings.
What it costs to be an S corporation
Payroll. You need a payroll system, quarterly payroll tax returns, and year-end W-2s.
A separate return. The company files Form 1120-S with the IRS and Form 100S with California.
California tax. California taxes S corporations at 1.5 percent of net income, with an $800 minimum. An LLC taxed as a partnership or sole proprietorship pays an $800 annual tax plus a separate fee based on its total California income, which starts at $900 once that income reaches $250,000 and rises to $11,790 at $5 million or more. Depending on your numbers, the election can raise or lower your California cost.
The QBI deduction. The 20 percent qualified business income deduction, now permanent, does not apply to your salary, so a higher salary can reduce it. California does not allow this deduction at all.
Rules that limit who can elect
An S corporation can have no more than 100 shareholders and only one class of stock. Shareholders are generally limited to individuals who are U.S. citizens or residents, estates, certain trusts, and certain tax-exempt organizations. Partnerships, corporations, and nonresident aliens cannot be shareholders.
Profit and distributions also have to follow ownership percentages. A partnership can agree to split profit differently from ownership. An S corporation cannot.
When the election tends to make sense
There is no single profit number at which the S election always wins. It tends to make sense when:
the business has steady profit well above a reasonable salary for the owner's role,
that profit is expected to continue, and
the owner is ready for payroll and the extra bookkeeping.
It usually does not make sense when profit is small or unpredictable, when the business will hold real estate that is likely to appreciate, or when the owners want flexible profit splits.
Timing the election
For an election to take effect for a calendar year, Form 2553 is generally due no more than 2 months and 15 days after the year begins, which is March 15 for most businesses. An election filed during the year before can take effect the following January 1. If the deadline was missed, relief is often available within 3 years and 75 days of the intended effective date, when there was reasonable cause and the business and its owners have reported consistently with S status.
Fall is a good time to model 2027. If the numbers support it, the election can be filed so it takes effect on January 1.
Book your planning call
If you want to see what an S election would mean for your business, book a time with our team at calendly.com/kirkcole/15-minute-meeting.
This article is general information, not tax advice for your situation. Tax rules change, and the right move depends on your facts.