The LLC vs the S Corporation

Keith croppedThere is a lot of confusion among small business owners when deciding on their entity classification and the tax savings involved. It is the first discussion I have with most business clients. It takes time to get pertinent information out so I decided it would be a good idea to write down.

There are five business entity choices, but it really is only three since two are default choices: sole proprietorship, partnership, limited liability company (and its close cousin, the limited liability partnership), regular corporation (also called a C corporation) and the S corporation. You default to a sole proprietorship if you are a one-person business or a partnership when two or more owners are involved.


Most attorneys feel every business ought to be an LLC. I agree with the attorneys on this and not only for legal reasons. I like to tell people LLCs are like tuna, it takes on the flavor of whatever you put it with. A single member LLC defaults to a sole proprietorship and joint owners to a partnership. There are no LLC tax forms (with the exception of the “check in the box” election form). A single member files a Schedule C on their personal return; a partnership files Form 1065 like any other partnership. Sole proprietor and partnership tax rules apply accordingly.

An LLC can also take on the flavor of a regular corporation or an S corporation by making a simple election. The “check in the box” election informs the IRS how you want to conduct your business. Most of you don’t want to follow regular corporation tax rules so you will file a second form electing to be treated as an S corporation.

Regular corporations pay their own taxes and dividends paid to the owners are not deductible by the corporation and are therefore double taxed. S corporation profits flow to the owner’s personal tax return and are only taxed on the personal level. Corporations must pay owners a reasonable wage. If you are wrapping your mind around this concept you will naturally want your wages from your LLC/S corporation as low as possible to avoid self-employment taxes on the pass-through profits. The IRS knows this and requires a reasonable wage, but reasonable is a wide road. The tax court is littered with cases on fair compensation. The IRS has provided a safe harbor of 60% of profit as a reasonable wage.

Example: You have an S corporation with $200,000 before owner’s payroll. Safe harbor for owner’s wages are $120,000.

51r-Q3dz1ML._SX388_BO1,204,203,200_Is it possible to have a lower wage and still be reasonable? Yes. A safe harbor is just that, a place where the IRS agrees not to challenge your position. Many owners will not use the safe harbor method. If you have employees (let’s say 20), a large portion of the profit is derived from said employees. Remember why S corporations exist. They allow small firms to conduct business without the negative tax rules of a large regular corporation while still maintaining the legal protection of the corporate structure. The concept of the S corporation is to allow profits from non-owner’s work (passive income) to flow through to the owners without the double taxation of regular corporation dividends or self-employment taxes on the profits derived from employees.

Small businesses frequently have several employees or subcontractors. A reasonable wage for owners may be higher or lower than 60%. Safe harbor is 60% so we can hang our hat on that nail as an owner’s wage ceiling. The higher the profits, the more likely the safe harbor will only be a guideline. There are several places online to find reasonable compensation numbers. Robert Half has a temp agency (Accountemps) that publishes reasonable compensation numbers for a large number of professionals; unemployment offices in most states do as well.

Legal Talk

Before we start this part of the discussion I want to remind you I am not an attorney. I encourage you to consult a competent attorney if you have any questions. I only provide my understanding of LLC versus S corporation law as it pertains to taxes.

What is the difference between an LLC and S corporation? Both provide legal protection. It is easier to understand LLCs when you understand why they were created. LLCs were created for legal, medical, and accounting firms. The reason LLCs were needed for these industries is because regular corporation tax laws are devastating to service corporations (you pay the top tax rate on every dollar of profit) and S corporations back then could only have 25 owners (100 owners allowed now). The other drawback of a corporation is the liability issue of all-acts versus own-acts.

An attorney can explain all the different rules between an LLC and corporation, both C and S. We will not dive into those details. There is only one legal area we will review. Remember, I am not an attorney. What I share here is how I understand the laws regarding LLCs and corporations.

The difference between LLCs and corporations involves something called own-acts and all-acts. As I understand it, LLC owners are only liable for own-acts while corporation owners are liable for all-acts. This is easiest to understand with an illustration.

41a3MMVh6EL._SX331_BO1,204,203,200_We will use a medical firm as our example. Suppose two groups of doctors get together to start a clinic. One group of doctors organizes as an S corporation, the other as an LLC. After some time in business both clinics suffer a malpractice lawsuit against one of their doctors. Unfortunately, both doctors lose their suit and own a huge settlement. In the S corporation, owners are liable for all-acts; therefore, all doctors are liable for the one doctor’s malpractice. The same situation happens in the LLC clinic. However, with an LLC, liability is only for own-acts; only the doctor sued is liable; the other doctors are protected from loss by the LLC.

Once again, review your situation with an attorney. Feel free to leave comments below. If I verify additional information, I will include it in a future edit.

Show me the Money

Now we get to the part I love the most, the money. How much money can you save in taxes with an LLC treated as an S corporation? To make it clearer for everyone I want to start with a really small company example and work up in size. We will assume our small business owner organized as a LLC from day one, but only elected to be treated as an S corporation at the appropriate time.

The micro business: We start our example with a small home-based business earning a modest $10,000 of profit per year. At this low level of profit electing to be treated as an S corporation is inadvisable. The cost of filing the extra tax return for the S corporation would eat up more than the tax savings. There is still one thing a business owner can do: rent out a portion of his home to his LLC.

Let me review the office in home rules. A single member LLC treated as a sole proprietor will follow office in home rules like a sole proprietor will with one additional option. The office in the home must be regular and exclusive. This means you can’t deduct a corner of the living room you use sometimes. The office in the home must be an exclusive area of the home (like a spare bedroom) and used only for the business.

The LLC is a person in the eyes of the law. (Remember Mitt Romney raising people’s ire when he said this on the campaign trail. He actually was right, even if his delivery could use some work.) Just because your business is reported with your personal tax return does not change the fact that the LLC is a person. Therefore, the LLC can rent space in your home from you. You must have a rent agreement between you and the LLC. You don’t need anything fancy. A simple commercial rental agreement will meet IRS requirements.

The LLC can deduct the full amount of the rent. With an office in the home it must be “regular and exclusive”. For a rent agreement between you and the LLC it only has to be for the benefit of the LLC, a much lower bar to hurdle.

Let me illustrate with some numbers:

Office in the home:

Profit: $10,000

Safe harbor deduction of spare bedroom office used “regular and exclusive”: $720 ($5 per square foot x 144 (a 12×12 room))

Business profit after office in the home deduction: $9,280

Self-employment tax: $1,420 (we round numbers when we prepare taxes.

Income tax (assume 15% federal; 5% state): $1,856

Total taxes attributed to the business: $1420 + 1856 = $3,276 total tax

LLC renting space in your home:

Profit: $10,000

Fair rental value of bedroom office, plus storage area of part of the garage and work area used in the basement: $500 per month; $6,000 per year

Business profit after office rent expense: $4000

Self-employment tax: $612

Rental income: $6,000 – rental portion of home expenses (mortgage interest, property tax, repairs and maintenance and depreciation) $720 (to keep consistent with the above example) = $5,280

Income tax: $4,000 (business profit) + $5,280 (rental profit) = $9,280 x 20% = $1856

Total taxes attributable to the business: $612 + $1,856 = $2,468

Total savings doing it the Wealthy Accountant way: $3,276 – $2,468 = $808

Not bad for a company only earning a $10,000 profit!

The next business we will review earns a $30,000 profit per year. I consider the $30,000 to $50,000 range a no-man’s zone. A $30,000 company can benefit from an LLC elected as an S corporation in some cases, depending on the industry. By the time you reach $50,000 it is easier to get enough tax benefits to offset the additional costs of an S corporation (payroll service expense and tax prep fee for the additional S corporation tax return). Our example will consider the LLC treated as an S corporation.

Our example will assume a small home-based business, but will not consider the LLC renting from you; I will incorporate that into the wage data which will give us nearly the exact same answer without getting to long here.

As a sole proprietor:

Profit: $30,000

Self-employment tax: $4,590

Income tax federal and state at 20% combined: $6,000

Total tax: $10,590

Ouch! Now you can see why you start thinking of tax alternatives when your business starts generating $30,000 or more in profit. It becomes painful really fast.

As an S corporation:

Profit: $30,000 – $18,000 (owner’s wage) = $12,000

No self-employment tax.

Payroll tax: $18,000 x .153 = $2,754 (We will not consider unemployment taxes either.)

Income tax at 20%: $30,000 (profit plus wage) = $6,000

Total tax: $2,754 + $6,000 = $8,754

Total savings doing it the Wealthy Accountant way: $10,590 – $8,754 = $1,846

Better, but it still hurts having a business. Still, you get to keep over 6% more of your money.

As we move to higher levels of income we can introduce other methods of tax reduction. To keep our illustrations simple, however, I will review these additional tax cutting ideas in future posts. Always consider these illustrations as non-inclusive; there are always variables that will change the results. By painting a narrow brush stroke I can show how a strategy works in a vacuum.

The remainder of this post will provide a quick illustration of the tax savings for a non-home based S corporation over a sole proprietor at $50,000, $100,000, $150,000, $250,000, and $500,000 profit levels. Once we reach over $100,000 the Social Security portion of the self-employment/FICA tax begins to reach its threshold and the tax savings change. I’ll point this out when we get there.

Sole proprietor:

Profit: $50,000

Self-employment tax: $7,650

Income tax federal and state at 20% combined: $10,000

Total tax: $7,650 + $10,000 = $17,650

S corporation:

Profit: $50,000 – $30,000 (owner’s wage) = $20,000

No self-employment tax.

Payroll tax: $30,000 x .153 = $4,590

Income tax at 20%: $50,000 (profit plus wage) = $10,000

Total tax: $4,590 + $10,000 = $14,590

Total savings doing it the Wealthy Accountant way: $17,650 – $14,590 = $3,060

Sole proprietor:

Profit: $100,000

Self-employment tax: $15,300

Income tax federal and state at 25% combined: $25,000

Total tax: $15,300 + $25,000 = $40,300

S corporation:

Profit: $100,000 – $60,000 (owner’s wage) = $40,000

No self-employment tax.

Payroll tax: $60,000 x .153 = $9,180

Income tax at 25%: $100,000 (profit plus wage) = $25,000

Total tax: $9,180 + $25,000 = $34,180

Total savings doing it the Wealthy Accountant way: $40,300 – $34,180 = $6,120

At this point I assume there are employees of the S corporation other than owners and reasonable owner’s wages are less than the 60% safe harbor. The Social Security limit is $118,500 for 2016. Wages or profits (for sole proprietors) above this level only pay the 2.9 % Medicare portion of the self-employment tax or FICA tax (both employee and employer share).

Sole proprietor:

Profit: $150,000

Self-employment tax: $19,044

Income tax federal and state at 30% combined: $45,000

Total tax: $19,044 + $45,000 = $64,044

S corporation:

Profit: $150,000 – $70,000 (owner’s wage) = $80,000

No self-employment tax.

Payroll tax: $70,000 x .153 = $10,710

Income tax at 30%: $50,000 (profit plus wage) = $45,000

Total tax: $10,170 + $45,000 = $55,170

Total savings doing it the Wealthy Accountant way: $64,044 – $55,170 = $8,874

Sole proprietor:

Profit: $250,000

Self-employment tax: $21,944

Income tax federal and state at 40% combined: $100,000

Total tax: $21,944 + $100,000 = $121,944

S corporation:

Profit: $250,000 – $100,000 (owner’s wage) = $150,000

No self-employment tax.

Payroll tax: $100,000 x .153 = $15,300

Income tax at 40%: $250,000 (profit plus wage) = $100,000

Total tax: $15,300 + $100,000 = $115,300

Total savings doing it the Wealthy Accountant way: $121,944 – $115,300 = $6,644

Note: There is a bubble effect once your income hits a certain level. Your tax savings may decline if you don’t apply other tax strategies. Working in a vacuum illustrates how the tax saving affect different income levels.

Our final example will not consider and Affordable Healthcare taxes.

Sole proprietor:

Profit: $500,000

Self-employment tax: $29,194

Income tax federal and state at 40% combined: $200,000

Total tax: $29,194 + $200,000 = $229,194

S corporation:

Profit: $500,000 – $100,000 (owner’s wage) = $400,000

No self-employment tax.

Payroll tax: $100,000 x .153 = $15,300

Income tax at 40%: $500,000 (profit plus wage) = $200,000

Total tax: $15,300 + $200,000 = $215,300

Total savings doing it the Wealthy Accountant way: $229,194 – $215,300 = $13,894

A final thought: This area of tax law covers a complex issue. It is not the only tax cutting strategy a business can use, but a very important one. It is of vital importance to business owners if they wish to survive. Several factors could slightly diminish the illustrated tax advantages shown while a significant number of other tax opportunities can reduce the tax liability. If you started as a partnership, the tax savings approximately double, especially for a husband/wife partnership. Knocking $25,000 off the tax bill is meaningful money.

Even if you prepare your own taxes, a tax professional should help you set up your business entity and help you determine reasonable wages. So many factors can change the results. Your situation will differ based on facts and circumstances.

Note: I received many questions on forming an LLC or corporation. In my office we used a company for years called The Company Corporation. You can check out their service by clicking the highlighted text.They handle all U.S states. 

Keith Schroeder


  1. Tortoise Banker on February 10, 2016 at 1:13 pm


    Income tax at 30%: $50,000 (profit plus wage) = $45,000

    Should be $150,000

    Found you through MMM. First I’ve heard of benefits of S Corp over LLC. Will be good for my wife who is self-employed. Solidified my acknowledgment that not doing my own taxes is the right choice! Thanks!

    • Keith Schroeder on February 10, 2016 at 3:06 pm

      Thank you, Tortoise. It might take a day or two for me to catch up and get it fixed.

  2. Ingrid on February 11, 2016 at 1:08 am

    Could you clarify something for me? The title of this article is “LLC vs. S Corp,” but as i read thru, it does not seem like you’re comparing the 2 as separate items. Is it more accurate to call this “the LLC taxed as an S-Corp?” Sorry if this question is elementary, but i am really trying to understand this. I am on the cusp of setting up my own small freelancing business, and i was about to go all in as a normal LLC, but after reading MMM’s article and then coming to your site, it seems like LLC taxed as an S-corp is the way to go.

    • Keith Schroeder on February 11, 2016 at 7:19 am

      Sorry for the confusion, Ingrid. The comparison is between an LLC without the S Corp election and an LLC with the S Corp election, which follws S Corp tax laws. When you start a business an LLC is a good way to start. Unless you are certain your profits will be high enough you should not elect for S Corp status. You can always elect later.

      • Ingrid on February 12, 2016 at 12:30 pm

        THANK YOU!!!! Very very helpful.

  3. Aaron on February 11, 2016 at 9:49 pm

    I currently have an LLC and have considered switching to an S-Corp for your reasons above. I know I will save money now, and this may be a stupid question, but is paying into social security a bad investment? Guess I’m just thinking the more I pay in, the more I’ll get out in the form of a lifetime annuity. Maybe you’ve already done the math and analysis, if so would like to hear your opinion. Hope this makes sense.

    • Keith Schroeder on February 11, 2016 at 10:00 pm

      I assume you invest your saving rather than go on a spending spree. Also, the more you pay into Social Security the more you get at a diminishing return. Paying in more to Social Security does not mean your rate of return is higher. Some people will take a higher wage to increase their Social Security benefits, most do not need to.

  4. mark on February 13, 2016 at 2:55 am

    Is a public library a corporation of some kind?

    • Keith Schroeder on February 13, 2016 at 7:56 am

      I’m not sure. Non-profit organizations are corporations in every case I’ve seen, but I’ve never seen the numbers from a library. Now you have me thinking.

  5. Anders on February 14, 2016 at 2:04 pm

    OK, I got the 60/40 split of the net profit. Just a question and using your example:
    “Example: You have an S corporation with $200,000 before owner’s payroll. Safe harbor for owner’s wages are $120,000.”
    200,000 net profit
    20,000 benefits
    180,000 adjusted net profit
    108,000 owner payroll, payroll taxes etc
    72,000 dividends
    If the company pay $20k in benefits (health insurance/HSA/SEP) to the employee/owner (no other employees)
    will the benefits be accounted before or after net profit in your example?

    • Keith Schroeder on February 14, 2016 at 4:32 pm

      Benefits are part of your compensation. Also, the safe harbor works best with smaller firms. If your business has several employees and nets 200k before owner wages, it is possible reasonable compensation is less. If you have no other employees you may have contractors.

  6. Lucas on February 20, 2016 at 8:46 pm

    Very helpful comparison. I don’t need this yet at the moment, but likely will someday in the not to distant future when I am FI and running my own business on the side 🙂

  7. Jennifer on February 21, 2016 at 10:58 am

    I am enjoying your blog so much. Thank you for writing, its on my must read list!
    I am intrigued by the idea of my LLC renting home office space as an expense. What do you think about the risks of inviting an audit with this arrangement– Would it be scrutinized more than just a regular home office deduction?

    • Keith Schroeder on February 21, 2016 at 11:18 am

      S Corps are among the lowest audited of all tax returns; sole proprietors (Schedule C) the highest. I never leave a tax break on the table over fear of an audit.

  8. Mike on February 23, 2016 at 7:21 am

    I’d never considered renting my office from myself, and I skipped the office deduction last year over fear of the exclusive use hassle. Does simply having a rent agreement in place satisfy the requirement? How do you determine fair market rent?

    • Keith Schroeder on February 23, 2016 at 6:37 pm

      All you need is a simple lease agreement. I check the area for a reasonable per square foot rate, triple net, and use that rate.

      • Guillaume McDowell on August 21, 2017 at 5:16 am

        Some “gross” commercial leases in my area on a prominent pedestrian shopping street include a percentage of the gross revenue. Could such a lease be appropriate for an LLC out of a home office?

        • Keith Schroeder on August 21, 2017 at 7:44 pm

          Not sure what you mean. Can you explain further, Guillaume?

  9. Sherry Norman on February 26, 2016 at 12:23 am

    Hypothetical question : I buy an investment property (in an LLC) in a rapidly appreciating location. Without doing anything at all to the property (no renting it out, no fixing it up, nothing) I sell that property more than a year later for twice what I paid for it. Do I now have to pay payroll taxes and self-employed social security taxes on a portion of my profit because the transactions were done through an LLC? You can probably gather from the question that I’m confused by the whole concept since there was no work performed.

    • Keith Schroeder on February 26, 2016 at 6:02 am

      Your LLC is a disregarded entity and acts like any other investment property you own. The sale sale goes on Schedule D and is treated as a long-term capital gain. There is no SE tax or payroll tax on the sale.

  10. Sherry Norman on February 26, 2016 at 12:08 pm

    Please forgive my ignorance on this subject, and I don’t want to make it seem like I’m beating the subject to death, but I remain confused. What would be the defining characteristic or characteristics that makes a portion of the LLC profits subject to payroll/social security taxes? For instance, in the above example I posed of the sale of an investment property, if a contractor had performed some fix up on the property during the period I owned it, would a portion of my profit become subject to payroll/social security taxes because I had done the “work” of hiring and paying the contractor? Sorry again for my continued confusion, I guess I just keep thinking there’s a piece missing in my understanding of this concept.

    • Keith Schroeder on February 26, 2016 at 1:06 pm

      Taxes can be complex, Sherry. It is unlikely an investment property would ever be subject to payroll or SE taxes even if you worked on it. Real estate is generally passive income, not subject to FICA or SE tax.The LLC is only the legal entity holding the property. If the mentioned property were a rental property, the sale would go on Form 4797 with the capital gain going to Schedule D and recapture (a whole new story) going to ordinary income. (I made a very simple analogy. It is really slightly different, so tax pros, no flaming me.)

      Where would an investment property be subject to SE/FICA/payroll taxes? When you buy the property, fix it up and do so as a business. That means you do it a lot. If you are in the business of fixing up properties and reselling them you might be subject to payroll or SE taxes because you are a business, not an investor.

  11. nomoreanchorbabies on June 26, 2016 at 9:45 am

    Thanks, Keith. One question: if you take that last example, where the sole proprietor/LLC makes $500,000 in profit but the owner’s reasonable wage is much higher than $100,000 (if you are an attorney or physician, etc.), then the tax savings by filing as an S-corp isn’t anywhere near that, correct?

    • Keith Schroeder on June 27, 2016 at 8:46 am

      A reasonable wage for doctors and other high wage professions will change the illustrations in the article. I didn’t want to muddy the water with too many outside details. When income is higher there are alternative ways to reduce taxes. The S-corp is still a powerful tool, but will require adding additional strategies to reduce the tax burden. I could outline the details here, but it would be a whole new blog post. (Yes, I have posts in the queue in process on this subject matter.)

  12. Lance on March 6, 2017 at 8:05 pm

    Thanks for the great advice Keith! I have one question, what if I’m retired, living off my 60/40 stock/bond investments, but soon I get bored and start a business that makes $10,000 a year. Does it still make sense to do a LLC if I’m renting my home instead of owning it? Thanks!

    • Keith Schroeder on March 6, 2017 at 8:49 pm

      You might want an LLC , but the tax advantages are doubtful. There are other way to avoid FICA tax for a micro business.

  13. Patricia Forrest on March 24, 2017 at 7:24 am

    Excellent post, very complete information, thanks for sharing.
    If you need more information about what’s an LLC?, the difference between a C Corporation and an S Corporation or simply how to incorporate?
    I invite you to check it on Corporation USA where you will find various articles, forms and much more.

    • Keith Schroeder on March 24, 2017 at 10:53 am

      I briefly viewed the link Patricia provided. It looks legit to me and her site covers LLCs et cetera for countries around the world, including the U.S. Be aware they charge a fee for their service, The Wealthy Accountant is not an affiliate, and I have not vetted Corporation USA.

  14. […] world of S-Corps or LLCs. How do you know which one? In general, if a business generates more than $50,000 in profit a year, the business owner should establish an S-Corp by filing, among other things, a Form 2553. Any […]

  15. Matt K on May 5, 2017 at 5:18 pm

    Could you provide any official IRS guidance where they consider the 60/40 rule to be “safe harbor”. I can’t find anything from the IRS saying this exists, and I found several articles saying specifically that it does not exist:

    • Keith Schroeder on May 5, 2017 at 6:09 pm

      You bring up a good point, Matt. The problem with reasonable compensation is the lack of clear rules on the issue. Tax Court rulings frequently focus on unusually low wages by an owner or when they claim no wages at all. I called 60% of profits treated as wages as a “safe harbor” because if I open the compensation can of worms the post will get bogged down in a complex issue. In the next sentence I state “. . . the safe harbor will only be a guideline.” All the courts, Tax Court and regs say is “reasonable compensation.” That is a wide path. Once we start that discussion we have a very long blog post on only that subject and there would still be room to debate.

      The most important point to take is that owners must take a wage. 60% is a good starting point as I pointed out. The road from there is very wide and open to interpretation, depending which side of the debate you are on: S corp owners or the IRS. Facts and circumstances will determine the actual “reasonable compensation.” I don’t use the 60/40 rule in my office, but I do use it as a starting point.

  16. Grant on August 30, 2017 at 1:31 pm

    This is great! I would love to hear your thoughts on LLC with S-corp election vs straight S-Corp. If you were setting up a new venture, which would you choose?

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