One of the most common questions I hear from small business owners in Roselle and across Chicagoland is some version of this: "I formed an LLC. Was that the right call?" Sometimes it is. Often it is not. And the difference can cost thousands of dollars per year in unnecessary self-employment tax.
Let me walk through this the way I would in a consultation. The goal is not to give you a definitive answer in a blog post, because the right answer genuinely depends on your income level, how you pay yourself, and your long-term plans. But I can give you the framework that makes the decision clear.
What the Difference Actually Is
Both an LLC and an S Corporation are legal entity structures that provide limited liability protection. That is where the similarity ends, at least from a tax perspective.
An LLC with a single owner is taxed as a sole proprietorship by default. A multi-member LLC is taxed as a partnership. In both cases, all of the business net income passes through to your personal return, and all of it is subject to self-employment tax, which as of recent law is 15.3% on the first portion of earnings and 2.9% above that threshold.
An S Corporation changes this. With an S Corp, you are required to pay yourself a reasonable salary, and that salary is subject to payroll taxes. But the remaining business profit, distributed to you as a shareholder distribution, is not subject to self-employment tax. That distinction is where the savings come from.
A Simple Example
Say your business nets $150,000 after expenses. As an LLC taxed as a sole proprietor, the entire $150,000 is subject to self-employment tax. As an S Corp, you might pay yourself a reasonable salary of $80,000, with the remaining $70,000 distributed as a profit distribution. You pay payroll taxes on $80,000, not $150,000. The savings on that $70,000 can be meaningful, often in the range of $9,000 to $10,000 annually at current rates.
After four decades of reviewing business tax returns, I can tell you that the most common mistake I see is owners running everything through a single-member LLC well past the income level where an S Corp election would serve them better.
When an LLC Is the Right Choice
An LLC makes more sense than an S Corp in several situations. If your net business income is relatively modest, the administrative cost of running payroll and filing additional returns may outweigh the self-employment tax savings. A general rule of thumb: below approximately $40,000 to $50,000 in net business income, the math often favors staying as an LLC. But this threshold varies, and I always run the actual numbers for each client.
LLCs are also simpler to maintain. There are fewer formalities, no shareholder meeting requirements, and the cost to administer is lower. For a business just getting started, or a side operation that supplements other income, the LLC structure is often appropriate.
When an S Corp Election Makes Sense
As your business income grows, the case for an S Corp election strengthens. The optimal window is typically when net business income is consistently above $50,000 to $60,000, though this varies significantly based on your full income picture, state tax rules, and what a reasonable salary for your role looks like.
The S Corp election is also worth considering if you are planning to bring on additional owners, want to establish a cleaner separation between your salary and business profits for purposes of retirement planning, or are positioning the business for eventual sale.
What About the "Reasonable Salary" Requirement?
This is where S Corps require discipline. The IRS requires that S Corp owner-employees pay themselves a salary that is reasonable for the work they do. "Reasonable" is not defined in the code, but the IRS scrutinizes situations where owners pay themselves very low salaries to minimize payroll taxes. Getting this wrong can attract an audit and eliminate the tax advantages entirely. A CPA who understands your industry and business can help you establish a defensible salary level.
Other Factors Worth Considering
- State taxes: Illinois has its own rules around entity structure that affect the overall picture. The analysis is not purely federal.
- Retirement plans: Your entity structure affects which retirement plans are available and how much you can contribute. This can significantly change the net tax picture.
- Healthcare deductions: S Corp owners have specific rules around deducting health insurance premiums that differ from LLC rules.
- Transition timing: Switching from an LLC to an S Corp mid-year involves specific deadlines and elections. This is not a decision you want to make in December and expect to apply retroactively.
My Recommendation
Do not rely on a blog post, a friend's advice, or what worked for your neighbor to make this decision. I have seen businesses lose significant amounts of money on both sides of this decision: some paying unnecessary self-employment tax for years when an S Corp would have helped them, and others paying accountants to maintain an S Corp structure at an income level where it did not pencil out.
Have the conversation with a CPA who runs the numbers for your specific situation. That is exactly what we do at ProCFO.
Stephen Challinor, CPA, reviews entity structure for business owners across Roselle and greater Chicagoland. Schedule a consultation to get the analysis done right.