What Are the Tax Differences Between an S-Corp and an LLC?

Understanding the tax differences between an S-Corp and an LLC is essential for business owners, but the comparison requires a key clarification first: an LLC is a legal entity type created under state law, while an S-Corp is a federal tax election. An LLC can choose to be taxed as an S-Corp by filing Form 2553 with the IRS. So the real comparison is between an LLC taxed as a sole proprietorship (or partnership) and an LLC taxed as an S-Corp.

Self-Employment Tax Treatment

The most significant tax difference is in how self-employment taxes are applied. When an LLC is taxed as a sole proprietorship, all net business income flows to the owner's Schedule C and is subject to self-employment tax under IRC Section 1401 -- currently 12.4% for Social Security (up to the wage base of $168,600 in 2024) and 2.9% for Medicare on all earnings, plus the 0.9% Additional Medicare Tax on earned income above $200,000 ($250,000 for married filing jointly).

When an LLC elects S-Corp taxation, only the owner's reasonable salary is subject to FICA taxes. Profit distributions beyond the salary are exempt from Social Security and Medicare tax. For a business earning $250,000 with a reasonable salary of $100,000, the FICA savings can exceed $15,000 annually.

Income Tax Treatment

Both structures are pass-through entities -- business income flows through to the owner's personal tax return and is taxed at individual rates. There is no entity-level federal income tax for either an LLC taxed as a sole proprietorship or an LLC taxed as an S-Corp (though some states impose S-Corp franchise taxes or minimum taxes -- California, for example, charges a 1.5% S-Corp tax with a minimum of $800).

The Qualified Business Income (QBI) deduction under IRC Section 199A is available to both structures, allowing eligible taxpayers to deduct up to 20% of qualified business income. However, the deduction is calculated differently depending on the structure. For S-Corp shareholders, reasonable compensation (W-2 wages) paid to the owner counts toward the W-2 wage limitation that applies to specified service trades or businesses (SSTBs) at higher income levels. This can actually benefit S-Corp owners by creating a W-2 wage base that supports a larger QBI deduction in some scenarios.

Loss Deduction Rules

The rules for deducting business losses differ significantly. For an LLC taxed as a sole proprietorship, losses flow directly to the owner's return and are deductible against other income (subject to the passive activity rules under IRC Section 469 and the excess business loss limitation under IRC Section 461(l), which caps deductible business losses at $305,000 for single filers or $610,000 for joint filers in 2024).

For an S-Corp, loss deductions are subject to the shareholder basis limitation under IRC Section 1366(d). You can only deduct S-Corp losses to the extent of your stock and debt basis. Importantly, S-Corp shareholders only get basis from direct loans they make to the corporation -- they do not get basis from entity-level bank debt. This is a meaningful distinction from partnerships and sole proprietorships, where the owner's basis includes their share of the entity's liabilities under IRC Section 752.

Payroll and Administrative Requirements

An LLC taxed as a sole proprietorship has minimal administrative requirements -- no separate tax return (income is reported on Schedule C), no payroll obligations, and no requirement for corporate formalities. An S-Corp requires filing Form 1120-S annually, running payroll for owner-employees (including quarterly Form 941 filings, annual W-2 and W-3 preparation, and federal and state payroll tax deposits), and maintaining corporate records.

The added administrative cost typically ranges from $2,000 to $5,000 per year for payroll services and S-Corp return preparation. This cost must be weighed against the self-employment tax savings to determine whether the S-Corp election produces a net benefit.

Retirement Plan Contributions

Both structures allow retirement plan contributions, but the mechanics differ. An S-Corp owner-employee contributes to a 401(k) or SEP-IRA based on their W-2 salary, not on total business profit. A sole proprietor contributes based on net self-employment income. In some cases, the S-Corp salary structure can actually limit the maximum retirement plan contribution compared to a sole proprietorship, depending on income levels and the salary chosen. This is an important factor to model when comparing the two structures.

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This article is for informational purposes only and does not constitute legal or tax advice. Consult a qualified tax professional regarding your specific circumstances. AE Tax Advisors, 935 Lake Elmo Dr, Suite B, Billings, MT 59105. Phone: (631) 614-5762.