What Is an S Corp and Is It Right for Me?

What is an S corp?

An S corp is a tax designation that allows business profits to pass directly to owners' personal tax returns, avoiding corporate-level taxation. Unlike C corporations, which pay corporate income tax before distributing profits to shareholders, S corps avoid this double taxation. Both corporations and LLCs can elect S corp status by filing Form 2553 with the IRS.

To be an S corp, your business must:

• Have no more than 100 shareholders
• Not have non-resident alien shareholders
• Not have owners that are corporations or partnerships
• Have only one class of stock

Electing S corp taxation involves filing Form 2553 with the Internal Revenue Service (IRS), though you’ll want to be mindful of the deadlines (more on this later).

Advantages of an S corp for LLC owners

When an LLC is taxed as a sole proprietorship or partnership, the owners are considered self-employed. Owners will pay Social Security and Medicare taxes (known as self-employment taxes) on their full share of the company's profits.

If your business earns significant profits, you may save on self-employment taxes by choosing S corp taxation instead.

S corp owners who work in the business can be company employees, and they must pay themselves a reasonable salary for the work they do. Like all employees, they'll pay Social Security and Medicare taxes on that salary, but additional company profits won't be subject to these taxes.

Owner-employees can also participate in company benefit programs, including 401K and profit-sharing plans. However, some employee benefits like medical and life insurance can be taxable if an employee owns more than two percent of the company.

There are a few main disadvantages for LLC electing S corp status.

• Additional paperwork: You must elect S corp status with the IRS and run payroll with tax withholdings.
• IRS scrutiny: The IRS closely monitors whether owner-employees pay themselves a fair and reasonable salary.
• Cost vs. benefit: For small businesses with few profits, these added burdens can outweigh the tax savings.

How salary and distributions affect self-employment tax

When your LLC operates under default tax treatment (as a sole proprietorship or partnership), you pay a 15.3% self-employment tax on your entire profit. With S corp taxation, the tax treatment splits into two categories: 

1. You must pay yourself a reasonable salary for the work you perform, which is subject to payroll taxes (the equivalent of self-employment tax, but processed through formal payroll). 
2. Any remaining profit can be distributed to you as an owner distribution. These distributions are not subject to the 15.3% self-employment tax—they're only subject to ordinary income tax.

Here's an example: If your LLC generates $120,000 in net profit and you elect S corp status, you might pay yourself a $70,000 salary (subject to payroll taxes) and take the remaining $50,000 as distributions. You'd save approximately $7,650 in self-employment tax on that $50,000 distribution (15.3% × $50,000), minus the additional costs of running payroll and maintaining S corp compliance.

However, you can't simply label most of your income a "distribution" and call it a day. Because the IRS expects owner-employees to be paid fairly for their work, understanding what counts as reasonable compensation is key to keeping the tax benefits.

Determining reasonable compensation and what the IRS looks for

The IRS requires that S corp shareholder-employees receive reasonable compensation for the services they provide to the business, but there's no fixed formula or safe-harbor percentage. 

Instead, the IRS evaluates reasonable compensation using several criteria, such as:

• Training and experience. Your educational background, professional credentials, and years of experience in your field all influence what you should be paid. For instance, a seasoned consultant with 20 years of expertise would reasonably command a higher salary than someone just starting out.
• Duties and responsibilities. If you're the primary revenue generator, handle all client relationships, and manage operations, your salary should reflect that comprehensive responsibility.
• Time and effort devoted. How many hours do you work? Are you full-time or part-time? The time commitment directly impacts reasonable compensation expectations.
• Comparable salaries. What would you pay an unrelated third party to perform the same duties? Industry salary data, geographic location, and company size all factor into this comparison.
• Company profitability and financial condition. While a struggling business might justify lower compensation, a highly profitable S corp paying its owner-employee minimum wage while distributing hundreds of thousands in profits would likely raise red flags.

In practice, many tax professionals recommend that shareholder-employee salaries fall somewhere between 35%–50% of total business income, though this is a general guideline rather than a requirement. The key is documentation: maintain records showing how you determined your salary, including any salary surveys, industry comparisons, or professional advice you relied upon.

If the IRS determines your salary is unreasonably low, they might reclassify distributions as wages, assess back payroll taxes, and impose penalties and interest. The risk isn't theoretical—the IRS has won numerous cases where S corp owners paid themselves minimal salaries while taking substantial distributions.

C corp vs. S corp tax advantages

While large companies are typically C corporations, small business owners often prefer S corp taxation, because their profits aren't taxed at both the corporate and shareholder levels. However, S corp taxation isn't ideal for every business.

A company might benefit from C corp taxation if:

• It's a startup hoping to attract outside investment. Institutional investors usually prefer C corporations.
• It plans to keep money in the business to fund future growth. C corp shareholders only pay tax on money distributed to them, whereas S corp owners pay tax on all company profits.
• It doesn't meet the requirements for S corp taxation.

The tax advantages of an S corp depend on several factors, including your business' size, profitability, and structure. It's best to review your options with a tax professional who can help you make the right choice for your situation.