One of the most common misconceptions we encounter when advising small business owners is the belief that Limited Liability Companies (LLCs) and S-Corporations are competing business structures. You might have heard someone ask, “Should I form an LLC or an S-Corporation?” We even sometimes hear from a client that their accountant has advised them to “Reincorporate as an S-Corporation for the tax savings.” This question actually contains a fundamental misunderstanding that can lead to confusion, needless expense, and can even undermine the liability protections you’ve put in place through creating an LLC.

The Critical Distinction

Here’s the reality:

• An LLC is a business entity type created under state law
• An S-Corporation is a tax classification elected with the IRS

This distinction is crucial because it means you’re not choosing between an LLC and an S-Corporation. Rather, you’re first selecting your business entity (and I always start by asking, “Why not an LLC?”), and then determining how that entity will be taxed.

How LLCs Are Typically Taxed

By default, LLCs are taxed according to their ownership structure:

• Single-member LLCs are taxed as sole proprietorships (pass-through taxation on your personal return, Schedule C)
• Multi-member LLCs are taxed as partnerships (Form 1065 with K-1s for each member)

These default tax treatments offer simplicity and flexibility, which is why many small business owners choose the LLC structure in the first place.

The S-Corporation Tax Election

Here’s where S-Corporations enter the picture: an LLC can elect to be taxed as an S-Corporation while maintaining its LLC legal structure. This is done by filing Form 2553 with the IRS.

When an LLC elects S-Corporation taxation:

1. The business remains an LLC under state law
2. The business files Form 1120-S for federal taxes
3. The owners receive K-1 forms showing their share of business income
4. The business can potentially reduce self-employment taxes on a portion of income

Potential Benefits of S-Corporation Taxation

The primary advantage of S-Corporation taxation is the potential tax savings on self-employment taxes. With default LLC taxation, all profits are typically subject to self-employment tax (15.3% for Social Security and Medicare).

With S-Corporation taxation, you can:

1. Pay yourself a “reasonable salary” that is subject to employment taxes
2. Take additional profits as distributions that are not subject to self-employment taxes

This arrangement can result in significant tax savings for profitable businesses, though the exact amount depends on your specific financial situation.

Additional Requirements for S-Corporation Taxation

The potential tax benefits come with additional responsibilities:

1. Reasonable salary requirement: You must pay yourself a salary comparable to what would be paid for similar services in your industry (determining what is “reasonable” is very much an art and can be very complicated)
2. More formalized accounting: More detailed bookkeeping and clear separation between salary and distributions (your books tell a story, and that story needs to make sense under the laws you choose to take advantage of)
3. Ownership restrictions: Limited to 100 shareholders, one class of stock, and certain types of shareholders (typically, only humans with bellybuttons or their direct representatives like a trust or probate estate can own an interest in an S-Corporation)
4. Additional filing requirements: More complex tax returns and potential state tax considerations

When S-Corporation Taxation Makes Sense

S-Corporation taxation typically becomes advantageous when:

• Your business consistently generates profits above what would be a reasonable salary
• The tax savings outweigh the additional accounting and administrative costs
• You can satisfy the reasonable salary requirements and other restrictions

Common Pitfalls to Avoid

Many business owners make these mistakes:

1. Forming a corporation instead of an LLC when they simply want S-Corporation taxation
2. Making the S-election too early before their business generates sufficient profit
3. Taking too little salary to unreasonably minimize employment taxes (a red flag for IRS audits)
4. Not understanding or ignoring the additional compliance requirements

Making the Right Choice for Your Business

The decision about your business entity structure and its tax treatment should be based on several factors:

• Liability protection needs
• Administrative simplicity
• Growth plans (are you in business to live your life with it, or are you in it to grow and sell?)
• Profit projections
• Personal tax situation

Rather than asking “LLC or S-Corp?” the better questions are:

1. “What business entity provides the right liability protection and flexibility for my business?”

and

2. “How should my business entity be taxed to optimize my overall tax situation?”

Understanding that an LLC is a business entity while S-Corporation is a tax classification clears up much of the confusion surrounding this topic. In most cases, forming an LLC and then making an informed decision about its tax treatment (default or S-Corporation) provides the best combination of liability protection, flexibility, and potential tax advantages.

Ready to Get Your Business Structure Right?

Don't navigate these complex business decisions alone. At OH Law, we specialize in helping entrepreneurs choose the right business structure and tax strategy for their unique situations.

Schedule a new client consultation today to discuss your business goals and get personalized guidance on whether an LLC, S-Corporation tax election, or another approach is right for you. Our flat-fee business formation packages include all the documentation and guidance you need to establish your business on a solid legal foundation.

Disclaimer: This article provides general information and should not be construed as legal or tax advice. Every business situation is unique. Please consult with qualified legal and tax professionals for advice specific to your circumstances.