LLC vs S-corp in 2016: the payroll-tax crossover
Why the election starts paying for itself somewhere north of $60,000, and why the real variable is the ratio, not the revenue
Contents 4 sections
t what net income does the S-corp election start saving more in self-employment tax than it costs to run? The usual answer is $40,000, or $50,000, or some other number someone heard at a conference. The usable answer in 2016 is closer to $60,000 to $80,000 of net self-employment income, and even that is the wrong frame. The number that actually determines whether the election pays is the ratio of reasonable compensation to distributions — not the top-line revenue.
Most of the advice circulating on this question is wrong in a predictable direction. It treats the S-corp election as a switch that flips on at some magical revenue threshold and saves you 15.3% on everything above it. That is not how the math works, and it is not how the IRS reads the return.
Where the savings actually come from
A single-member LLC, by default, is a disregarded entity. Net income from the business lands on Schedule C of the owner's 1040 and is subject to self-employment tax on the full amount. In 2016, SE tax is 15.3% on the first $118,500 of combined wages and SE income (the 2016 Social Security wage base), 2.9% Medicare on everything above that, and an additional 0.9% Medicare on earned income over $200,000 for a single filer ($250,000 for a married couple filing jointly). The SE deduction on the 1040 softens the bite slightly but does not change the shape.
An S-corp — whether the entity is an LLC that filed Form 2553 or a state-law corporation — splits the owner's take into two streams. The owner must pay themselves "reasonable compensation" as a W-2 employee. That wage is subject to FICA: 6.2% Social Security from the employee and another 6.2% from the employer, plus 1.45% Medicare on each side, for the same 15.3% total up to the wage base. Everything left over after reasonable compensation comes out as a distribution, which is not subject to self-employment or payroll tax at all.
The savings are entirely in the distribution slice. If you pay yourself 100% of net income as salary, the S-corp election saves you nothing and costs you payroll-processing fees. If you pay yourself $1 and take the rest as a distribution, the IRS disallows the position and reclassifies the distributions as wages, with penalties. The real game is how defensible a compensation figure you can anchor, and how much of the total take sits above it.
A $120,000 example
Take a consultant with $120,000 of net business income in 2016, no other wages, filing single.
As a single-member LLC taxed as a disregarded entity, the full $120,000 runs through Schedule C and SE tax. The SE tax base is 92.35% of net earnings, or roughly $110,820. SE tax is 15.3% on that, because the entire amount sits under the $118,500 wage base, which comes to about $16,955. (The employer-equivalent half is deductible above the line, so the effective hit is a little lighter, but the cash out the door in payroll-equivalent tax is about $17,000.)
Now run the same $120,000 through an S-corp. Suppose the consultant can defend $70,000 as reasonable compensation for the work performed — a number that would pass a casual IRS review for a mid-career professional in most markets. FICA on $70,000 of wages is 15.3%, or $10,710, split between employee and employer sides but ultimately paid by the same person. The remaining $50,000 comes out as a distribution, subject to income tax but not to payroll tax. Savings versus the LLC path: roughly $6,200 before considering the administrative overhead.
Move the reasonable-comp figure and the math moves with it. At $90,000 of salary and $30,000 of distribution, savings shrink to about $3,700. At $50,000 of salary and $70,000 of distribution, savings climb to about $8,700 — but the IRS is likelier to notice a 42% compensation ratio than a 58% one, and the penalty on a reclassification wipes out several years of savings.
This is why the crossover is a range rather than a threshold. Below roughly $60,000 of net SE income, there isn't enough distribution slice left, after a defensible wage, to cover the overhead. Above roughly $80,000, the math starts to work for most professional-services patterns. Between those, it depends on what a reasonable wage looks like in the owner's field, and on how patient the owner is with compliance.
The admin burden, in detail
The S-corp election turns a Schedule C into an 1120-S, a K-1, a W-2, and quarterly payroll filings. Each of those has a real cost.
Running payroll for a single owner requires either a service (Gusto, ADP, Paychex, or similar, running $40 to $100 a month in 2016) or the kind of manual 941 and state unemployment filings that eat a Saturday each quarter. The 1120-S itself typically costs $800 to $1,500 at a competent small-firm CPA, versus maybe $300 to $500 added to a 1040 for a Schedule C.
Reasonable compensation is not a line you draw and forget. If the IRS examines the return, the agent will want to see comparables — payroll surveys, job postings, partnership profit-per-partner figures — and a contemporaneous rationale. Keep a one-page memo in the file. Founders who cannot articulate why $70,000 is reasonable for their work are the ones who lose on audit.
The 2% shareholder health-insurance rule is the quirk that surprises owners most often. An S-corp can deduct health-insurance premiums paid for a more-than-2% shareholder, but the premiums must be added to the shareholder's W-2 wages as taxable income (not subject to FICA, but reported on the W-2). The shareholder then deducts the premiums above the line on the 1040. Miss the W-2 reporting step and the deduction is at risk. HSA contributions follow a similar pattern. This is the kind of detail that gets fumbled when owners try to DIY the payroll.
State-level treatment deserves its own paragraph. California imposes a 1.5% franchise tax on S-corp net income, with an $800 minimum. For a California-resident owner running $120,000 through an S-corp, that is another $1,800 off the top, which closes most of the federal payroll-tax gap and sometimes erases it. New York City imposes the General Corporation Tax on S-corps, which the state return does not offset. Tennessee and New Hampshire treat S-corps as C-corps for state purposes. Before electing, owners should price the election in their specific state, not the federal vacuum.
And one operational note: the S-corp election is due by March 15 of the year it takes effect, or within 75 days of formation. Late elections require a relief request under Rev. Proc. 2013-30, which the IRS grants liberally but not automatically. Electing in July 2016 for the 2016 tax year is still possible; electing in February 2017 for 2016 is a harder sell.
The one-sentence rule
If your net self-employment income is reliably above $80,000, your reasonable-comp figure sits below 70% of that, and you are not in a state that claws the savings back at the entity level, the S-corp election is usually worth the admin; below that, keep the LLC as a disregarded entity and revisit the question when revenue is less variable.