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Editorial 7 MIN READ

LLC vs S-corp: the payroll tax crossover

Where the S-election starts paying for itself, and the narrow band where it probably still doesn't

The Editors
Staff, Incorporator.org
7 min read Updated
Contents 9 sections
  1. The tax the LLC owner pays by default
  2. What the S-election changes
  3. The crossover math
  4. What running an S-corp actually costs
  5. The QBI wrinkle
  6. The election itself
  7. When not to elect
  8. A rule of thumb
  9. Sources

he LLC vs S-corp payroll tax crossover is a math problem dressed as a tax strategy. A single-member LLC owes self-employment tax on every dollar of net earnings; an S-corp owes payroll tax only on the wages it pays its owner. Somewhere between those two treatments is a number where the S-election starts paying for itself.

For most profitable one-owner service businesses in 2023, that number sits between roughly $60,000 and $80,000 of net earnings, after the cost of running payroll is honestly priced in. Below the band the election does not earn its keep. Above it, it compounds.

The tax the LLC owner pays by default

An LLC has no federal tax character of its own. By default, a single-member LLC is disregarded and a multi-member LLC is a partnership. In both cases, the owner's share of net earnings from self-employment flows to Schedule SE and is taxed under IRC § 1401: 12.4% Social Security up to the wage base, plus 2.9% Medicare on every dollar, for the familiar 15.3% combined rate. For 2023, the Social Security wage base is $160,200 (SSA, 2023 fact sheet). Above it, the 2.9% Medicare rate continues, plus the 0.9% Additional Medicare Tax over $200,000 single or $250,000 joint under IRC § 3101(b)(2).

The half-of-SE deduction under IRC § 164(f) softens the income-tax side but does nothing to reduce the 15.3% bite. A sole member with $120,000 of net earnings will pay SE tax on roughly $110,827 of it (net earnings times 92.35%), close to $17,000.

What the S-election changes

An LLC can elect S-corp treatment by filing Form 2553. The state-law entity does not change; the federal character does. Post election, the owner becomes an employee paid reasonable compensation subject to FICA at a combined 15.3% (split between employer and employee on the W-2, but the owner economically bears both sides). Remaining profit passes through as a K-1 distribution free of SE tax and FICA. That is the spread the election is trying to capture.

"Reasonable compensation" is not a number the owner gets to pick. The Eighth Circuit affirmed the doctrine in Watson v. United States, 668 F.3d 1008 (8th Cir. 2012), where an accountant who paid himself $24,000 in wages while taking roughly $200,000 in distributions had his wages recharacterized to about $91,000. The older authority the IRS still cites is Rev. Rul. 74-44, 1974-1 C.B. 287, holding that amounts paid to shareholder-employees as dividends in lieu of compensation are wages for FICA purposes. Any S-corp owner should be able to produce a comp study on audit.

The crossover math

Treat the reasonable-comp number as a fixed draw on payroll tax and the rest of the profit as the arbitrage.

Take a solo consultant with $100,000 of net earnings. As a default LLC, SE tax runs on 92.35% of that ($92,350) at 15.3%, or about $14,130.

Switch to S-corp with $60,000 of reasonable comp. FICA on the $60,000 wage runs at 15.3%, or $9,180. The remaining $40,000 passes as a distribution with no SE or FICA. The federal payroll-tax spread is roughly $14,130 minus $9,180, or about $4,950 saved. The half-of-SE deduction and the employer-side FICA deduction shift the income-tax math slightly; the first-order savings on the payroll side land in the $5,000 to $6,000 range at this income level. At $150,000 of net earnings with the same $60,000 reasonable comp, the arbitrage is a larger $90,000 distribution, and the savings move into five figures.

Under $60,000 of net earnings, there is almost nothing to arbitrage. Reasonable comp eats most of the profit, the distribution is small, and the cost of running payroll swallows the rest.

What running an S-corp actually costs

The election brings federal machinery. Form 1120-S with K-1s is due March 15. Quarterly Form 941 payroll-tax deposits. Annual W-2 and W-3 by January 31. State payroll registration for unemployment insurance and withholding, and in some states workers' comp even for a solo owner-employee. A payroll provider that handles the filings is the usual answer; the commodity tier runs roughly $40 to $100 per month. An 1120-S return done by a CPA typically costs several hundred to low four figures more than a Schedule C on a 1040.

Priced honestly, annual overhead lands between $1,500 and $3,000 for a one-person S-corp that outsources payroll and taxes. That is why the crossover is a band rather than a bright line. At $60,000 of net earnings the savings and the costs roughly cancel. By $80,000 the election clearly wins; below $60,000 it clearly loses.

The QBI wrinkle

The 20% qualified business income deduction under IRC § 199A is the other variable worth pricing in. For 2023, the taxable-income thresholds are $182,100 single and $364,200 married filing jointly before the specified-service-trade-or-business limits and the W-2-wage-and-UBIA limits kick in (Rev. Proc. 2022-38, § 3.27). Below the threshold, both an LLC and an S-corp get the deduction on their qualified income with no wage test. Above it, the W-2-wage limitation starts to matter, and here S-corp reasonable comp does real work: wages paid by the S-corp count toward the 50%-of-W-2-wages (or 25% of W-2 wages plus 2.5% of UBIA) cap. A disregarded LLC with no employees has no W-2 wages to test against for its own owner's labor.

The effect is not uniform. A high-earning consultant in a specified service trade (law, health, accounting, consulting, financial services and similar under IRC § 199A(d)(2)) phases out of QBI entirely above the threshold regardless of entity, so the S-corp wage trick does not save the deduction. A non-SSTB owner above the threshold can use S-corp wages to preserve QBI that a pure LLC would lose. That is a case where the S-election is doing tax work beyond the payroll-tax arbitrage.

The election itself

Form 2553 must be filed by the 15th day of the third month of the tax year, per IRC § 1362(b)(1). For a calendar-year entity that is March 15. File it late and the default is that the election takes effect the following year. Rev. Proc. 2013-30, 2013-36 I.R.B. 173, supplies the late-election relief most small filers rely on: if the entity qualifies and files within three years and 75 days of the intended effective date with a reasonable-cause statement, the IRS will treat the election as timely. It is not a substitute for filing on time.

Revoking is a separate process under IRC § 1362(d), and the five-year re-election bar in IRC § 1362(g) applies. Entities uncertain about committing should not elect lightly.

When not to elect

A handful of LLC shapes get worse under Subchapter S, not better.

Real-estate LLCs are the first and largest category. Rental income is generally not subject to SE tax under IRC § 1402(a)(1), so there is no arbitrage to capture. S-corps also follow stock-and-debt basis rules under IRC § 1366(d) that do not give shareholders outside basis for entity-level debt the way partnership rules do under IRC § 752, and distributions of appreciated property trigger gain at the entity level under IRC § 311(b). For a vehicle holding appreciating real estate, the S-election is the wrong machine.

Passive-investment entities are the second. An S-corp with former C-corp earnings and profits whose passive investment income exceeds 25% of gross receipts for three consecutive years can have its election terminated under IRC § 1362(d)(3), and the sting tax under IRC § 1375 can apply.

Multi-state operating LLCs get a third warning. Some states do not fully conform to the federal S-election and impose entity-level tax anyway (California's 1.5% S-corp franchise tax with an $800 minimum under R&TC § 23802 is the canonical example). Price state carve-outs before assuming the federal savings pass through.

Owners planning to take outside investors should also pause. An S-corp is capped at 100 shareholders, all US individuals or eligible trusts, with a single class of stock (IRC § 1361(b)). Anything headed for venture financing will have to re-convert before the first priced round.

A rule of thumb

If the business is an active service LLC clearing roughly $80,000 or more of net earnings after expenses, file Form 2553 and run payroll; below that, stay a disregarded LLC and keep the Schedule C.

Sources

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