Tax Talk Thursday: LLC vs. S Corp: Which One Is Right for Your Business?

It’s one of the most common questions small business owners ask us: “Should I stay an LLC or switch to an S Corp?”

The honest answer? It depends. And the factors that matter most — your profit level, your payroll setup, your appetite for paperwork, and your California tax picture — are different for every business.

This post breaks it all down in plain language. But first, take the quick quiz below. It’ll give you a starting point based on your own situation before we dig into the details.

What’s the Actual Difference Between an LLC and an S Corp?

First, a clarification that trips a lot of people up: an S Corp is not a separate business entity. It’s a tax election.

When you form a business, you typically register as an LLC (or corporation) with your state. That’s the legal structure. Separately, you choose how the IRS treats your business for tax purposes — and one of those options is S Corporation status.

So when people say “LLC vs. S Corp,” they’re really asking: should my LLC be taxed as a sole proprietorship (the default) or taxed as an S Corporation?

Default LLC taxation (sole proprietorship)

By default, a single-member LLC is a “disregarded entity.” All net profit flows directly to your personal tax return, and the IRS treats it as self-employment income. That means you pay:

•       Self-employment (SE) tax of 15.3% on all net profit (up to the Social Security wage

base)

•       Federal income tax on top of that

•       California income tax, plus the $800/year LLC minimum franchise tax

S Corp taxation

When you elect S Corp status, you split your income into two buckets:

•       Salary: You pay yourself a “reasonable salary” as a W-2 employee. This is subject

to payroll taxes (both employer and employee sides of FICA).

•       Distributions: Any remaining profit above your salary is taken as an owner

distribution — not subject to SE tax.

The tax savings come from the distribution portion. You’re not avoiding income tax on it — you’re avoiding the 15.3% SE tax on that slice of profit.

The Math: What Does the Savings Actually Look Like?

Let’s use a straightforward example with $100,000 in net profit.

	LLC (Default)	S Corp Election
Net Profit	$100,000	$100,000
Owner Salary	N/A	$60,000
Distribution	N/A	$40,000
SE / Payroll Tax	~$14,130	~$8,478
Est. Annual Savings	—	~$5,652

* Estimates based on 2024 SE tax rates. Actual savings depend on salary level, state taxes, and payroll costs. For illustration only.

In this example, the S Corp election saves roughly $5,600 per year in SE tax. But here’s the catch: running an S Corp costs money too. Payroll setup, quarterly filings, an additional California franchise tax, and higher CPA fees can easily run $2,000–$4,000 per year. That’s why the savings need to be large enough to justify the overhead.

General rule of thumb:

The S Corp election typically starts making sense when net profit consistently exceeds $60,000–$80,000 per year. Below that threshold, the administrative costs often eat the savings.

The Reasonable Salary Requirement (This Is the Part People Miss)

The IRS requires S Corp owner-employees to pay themselves a “reasonable salary” before taking distributions. This is one of the most scrutinized areas of S Corp compliance — and getting it wrong can trigger penalties, back taxes, and audits.

What’s reasonable? The IRS looks at:

•       What you’d pay someone else to do the same work

•       Industry norms for your role and revenue level

•       Your actual time and responsibilities in the business

You can’t pay yourself $20,000 and take $180,000 in distributions just to minimize payroll taxes. Courts have consistently sided with the IRS when salary is clearly too low relative to the services provided.

This is one reason why S Corp elections benefit from professional guidance — setting the salary correctly from the start protects you and maximizes the benefit.

The California Factor

If you’re a California-based business — and most of our clients in the LA and San Gabriel Valley are — there’s an extra layer to the calculation.

California charges S Corporations a 1.5% franchise tax on net income, with a minimum of $800 per year. LLCs also pay the $800 minimum, plus an additional fee based on total gross receipts (not net profit). Depending on your revenue level, the LLC fee structure may actually be a factor in favor of an S Corp election.

California LLC Annual Fees (based on gross receipts):

$0 – $249,999:  $800 minimum

$250,000 – $499,999:  $900

$500,000 – $999,999:  $2,500

$1,000,000 – $4,999,999:  $6,000

$5,000,000+:  $11,790

For higher-revenue businesses, the LLC fee alone can make an S Corp election attractive even before factoring in SE tax savings. Your CPA should model both scenarios using your actual numbers.

What the S Corp Election Actually Involves

If you decide to move forward, here’s what the process looks like:

•       File IRS Form 2553 (“Election by a Small Business Corporation”) — generally due by

March 15 for the election to take effect in the current tax year

•       File California Form 3560 for state-level S Corp election

•       Set up payroll — you’ll need an EIN (if you don’t have one), payroll software or a

payroll service, and quarterly 941 filings

•       File Form 1120-S (federal S Corp return) and California Form 100S annually

•       Issue yourself a W-2 at year-end

•       Keep records of shareholder distributions separately from salary

It’s more moving parts than a default LLC — which is why having a CPA who handles this regularly is important. Done right, it runs smoothly. Done wrong, it creates compliance headaches that cost more to fix than the original savings.

When to Stay an LLC (For Now)

The S Corp election isn’t right for everyone, and there’s no shame in keeping your LLC structure while you’re building. Here’s when it usually makes sense to wait:

•       Profit is under $60K: The overhead costs likely eat the tax savings.

•       You’re in early growth: Reinvesting profit back into the business means taxable

income varies widely year to year — locking into a payroll structure too early can create cash flow problems.

•       Your income is unpredictable: Payroll obligations are fixed even when revenue

dips. An LLC with pass-through taxation is more flexible.

•       You have partners or investors: S Corps have restrictions on who can be

shareholders (no foreign nationals, no other corporations, max 100 shareholders). An LLC may preserve more flexibility.

The good news: you can revisit this decision every year. If your profit grows to the point where the S Corp math makes sense, you can elect at that time.

The Bottom Line

The LLC vs. S Corp decision isn’t about which structure sounds better — it’s about the numbers specific to your business. Key questions to answer:

•       What is my consistent net profit?

•       What would a reasonable salary for my role look like?

•       What will payroll setup and annual compliance cost me?

•       What does the California franchise tax picture look like at my revenue level?

When you run those numbers side by side, the right answer usually becomes clear. And if it doesn’t, that’s what we’re here for.

Ready to Run the Numbers?

If you’re not sure where you fall — or you’re already operating and want to know whether an election makes sense for this tax year — our team can do a full comparison using your actual profit and California tax picture.

Email us: info@mkhstaxgroup.com