S-Corp Election vs. Default LLC Taxation: When the Switch Actually Saves Money

The S-corporation election is the most oversold idea in small-business tax. It is also, at the right profit level, one of the few moves that genuinely puts thousands back in your pocket each year. The difference is arithmetic — and almost nobody shows you the parts that cut against making the election. Here it is, worked at three profit levels, with the costs subtracted rather than ignored.

An LLC is not a tax status

"Should I be an LLC or an S-corp?" cannot be answered, because the two are not alternatives. An LLC is a legal entity created under state law: it governs who owns the business and who can be sued, and says nothing about how the business is taxed.

Tax treatment is a separate choice. By default a single-member LLC is disregarded — the IRS ignores it and you report the business on Schedule C of your Form 1040, exactly as a sole proprietor would. A multi-member LLC defaults to partnership treatment on Form 1065. Either can instead elect S-corporation treatment by filing Form 2553.

The real question, then: keep the default treatment, or elect S-corporation treatment? You dissolve nothing and re-register nothing; only the return changes.

How self-employment tax works by default

On a default single-member LLC your whole net profit is subject to self-employment tax — the freelancer's version of Social Security and Medicare, where you pay both the employee and employer halves. The rate is 15.3%: 12.4% Social Security plus 2.9% Medicare.

Two details drive the numbers below. The tax applies to 92.35% of net profit, not all of it. And the 12.4% Social Security portion stops at the annual wage base, $184,500 for 2026. Medicare has no ceiling, and an extra 0.9% applies above $200,000 for a single filer.

What the S-election actually changes

Elect S-corporation treatment and you become an employee of your own company. Profit splits into two streams:

• W-2 wages — a salary paid through real payroll, subject to the same 15.3%, half withheld and half paid by the company.
• Distributions — the profit left over, facing income tax but no Social Security or Medicare tax at all.

That is the entire saving. Not a lower income tax rate — income tax is essentially unchanged. Just 15.3% avoided on the profit taken as distributions. The saving is proportional to profit above a defensible salary, which is why the election does nothing for a modest business.

The numbers at three profit levels

One wrinkle in the $200,000 column: the $184,700 subject to self-employment tax edges past the $184,500 wage base, so the tax is 12.4% on $184,500 ($22,878) plus 2.9% on $184,700 ($5,356) — $28,234, not a flat 15.3%. Past roughly $200,000 of profit the Social Security saving stops growing, because a sole proprietor caps out too.

The costs most articles leave out

The $2,197 above is not a guess — it is a year of running an S-corporation, at our own published prices.

Additional state business returns are $145 each (an extra state on your personal return is $95), and states with their own S-corporation taxes or minimum fees add more; full scope is on our pricing page. Whoever you use, the added cost stays roughly fixed while the saving scales with profit.

The QBI deduction takes some of it back

Here is the part almost always missing. The Section 199A qualified business income deduction lets most pass-through owners deduct up to 20% of business profit, and the One Big Beautiful Bill Act made it permanent. The catch: wages you pay yourself are not qualified business income. Every dollar moved from distributions into salary leaves the 20% base, as does the employer payroll tax on it. A $60,000 salary removes roughly $64,590 from QBI.

At $60,000 the election loses money. At $100,000 it clears under a thousand dollars — real, but thin enough that one extra state fee erases it. Only at $200,000 is it worth restructuring around. The QBI deduction is also capped at 20% of taxable income after the standard deduction, which is why the default-LLC figures fall below a flat 20% of profit.

Reasonable compensation is the whole ballgame

You cannot pay yourself $10,000 and take $190,000 in distributions. The IRS requires S-corporations to pay reasonable compensation to a shareholder-employee for services performed before non-wage distributions are made. Where wages are unreasonably low, the IRS can recharacterise distributions as wages and assess the payroll tax, penalties and interest that follow — a power courts have repeatedly upheld, most prominently in Watson v. United States.

The IRS weighs your training and experience; your duties and responsibilities; the time and effort you devote; dividend history; what the company pays non-shareholder employees; how it pays bonuses to key people; what comparable businesses pay for similar services; and any compensation agreements or formulas. It also asks how much revenue comes from your personal services rather than from other employees or from capital and equipment. A consultant who is the business needs a high wage ratio; a business whose profit comes largely from staff or equipment can justify a lower one. The aggressive wage that makes a spreadsheet look good is the same wage that makes the election indefensible; every scenario above uses one we would be comfortable documenting.

Retirement plans and the wage limitation

Retirement contributions. In a solo 401(k), the employer profit-sharing contribution for a shareholder-employee is capped at 25% of W-2 compensation. On a $110,000 wage that is $27,500, on top of the $24,500 elective deferral limit for 2026. Cut the wage to $50,000 and the employer contribution caps at $12,500 — trading $15,000 of tax-deferred room for a few thousand dollars of payroll tax. Usually a bad deal.

The QBI wage limitation. Once taxable income passes the 2026 threshold of $201,750 for single filers ($403,500 married filing jointly), the QBI deduction stops being a simple 20% and becomes capped by a formula: the greater of 50% of the W-2 wages the business paid, or 25% of wages plus 2.5% of the cost of qualified property. A sole proprietor with no employees pays no W-2 wages, so at high income that cap can wipe the deduction out; an S-corporation paying a real salary keeps a wage figure in the formula. Above the threshold, then, a higher wage can be worth more than the payroll tax it costs. Below it — all three scenarios above — the logic reverses.

State-level traps

States consume federal savings more often than people expect:

• Jurisdictions that ignore the election. Tennessee, New Hampshire, the District of Columbia and New York City largely tax S-corporations as ordinary corporations — in New York City, the general corporation tax applies on top of everything else.
• California. A 1.5% franchise tax on net income, with an $800 annual minimum due whether the business is profitable, dormant or loss-making. In the $200,000 example, with $110,000 in wages, that is about $1,200 on the remaining corporate income.
• Illinois. A 1.5% personal property replacement tax on S-corporation income.
• New York State. The federal election is not automatically recognised — you must file a separate Form CT-6 with every shareholder's consent, or you end up a federal S-corporation and a state C-corporation.

The Form 2553 deadline, and missing it

Form 2553 must be filed no more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or at any point during the preceding tax year. For a calendar-year business wanting it effective for 2027, that means March 15, 2027.

What you are signing up for

In plain terms: real payroll on a fixed schedule, withholding remitted on time; quarterly Form 941s and an annual Form 940; a W-2 to yourself each January; a separate Form 1120-S by March 15 with a Schedule K-1; a genuinely separate business bank account; stock basis tracked so distributions do not become taxable; and state payroll accounts wherever you have a work location.

Miss a payroll tax deposit and the penalties are among the harshest the IRS levies. File the 1120-S late and the penalty accrues per shareholder per month. None of this is hard once someone watches the calendar — but it is why the honest breakeven sits higher than most articles suggest.

A decision checklist

1. Is profit consistently into the high five figures? On the wage assumptions used here the election turns positive between $60,000 and $100,000 of profit — and one good year is not a reason to elect.
2. What wage could you defend? Price the job you actually do. If a defensible wage absorbs most of the profit, nothing is left to save on.
3. What does your state do? Franchise taxes, minimum fees, separate elections and non-recognition can eat the whole federal benefit.
4. Are you under the QBI threshold? Below $201,750 of taxable income (single) the QBI clawback works against the election; above it, the wage limitation can work for it.
5. How much are you putting into retirement? A low wage caps employer contributions at 25% of that wage.
6. Will you keep up with payroll and a second return? A saving you spend on penalties is not a saving.

If profit is comfortably into six figures and your state is friendly, the election is usually worth making — properly, with a documented wage. Near the line, it comes down to your own details, which is what our tax planning and projection work is for: we model your numbers, in your state, with a reasonable-compensation figure we can support, and give you the net benefit after every cost — including the answer "don't do it," which we give often. Fees for that analysis, Form 2553, payroll and the Form 1120-S are listed on our pricing page.

Key takeaways

• "LLC vs. S-corp" is the wrong question. An LLC is a state-law entity; S-corporation is a federal tax election it makes on Form 2553, changing nothing about the company itself.
• The only saving is payroll tax on distributions. Default treatment applies 15.3% self-employment tax to 92.35% of profit; the election limits that tax to your W-2 wage.
• At $60,000 of profit it loses money. On these numbers: −$384 at $60,000, +$930 at $100,000, +$4,973 at $200,000, after $2,197 of added annual cost and the QBI effect.
• The QBI deduction claws back much of the saving, because wages are not qualified business income — a factor most comparisons omit.
• A low wage is not free. It invites recharacterisation, caps employer retirement contributions at 25% of compensation, and above the income threshold shrinks the QBI deduction.
• Check your state first. California's 1.5% franchise tax and $800 minimum, Illinois's 1.5% replacement tax, New York's separate CT-6 election, and non-recognition in Tennessee, New Hampshire, D.C. and New York City can reverse the answer.