An S-Corp election does not change what your business is. Your LLC stays an LLC under state law. The election only changes how the IRS taxes it. For the right business it reduces self-employment tax. For the wrong one it adds cost and paperwork for nothing. The decision comes down to a projection, not a slogan.
What the election actually changes
By default, the IRS ignores a single-member LLC for income tax purposes and treats a multi-member LLC as a partnership. Either way, the owners' share of net profit is generally subject to self-employment tax: 12.4% for Social Security up to the annual wage base, 2.9% for Medicare on all of it, and an extra 0.9% Medicare tax above $200,000 of earnings ($250,000 for joint filers).
After an S-Corp election, the IRS treats the LLC as an S corporation. The owner who works in the business becomes an employee and must be paid a reasonable salary through payroll. That salary carries the usual payroll taxes. Profit left after salary and expenses can be taken as a distribution, and distributions are not subject to self-employment or payroll tax. That gap, between the salary and the total profit, is where the savings come from.
What it costs to run
- Payroll. You need a payroll service, quarterly and annual payroll filings, W-2s, and unemployment insurance. Budget for the service fee and the employer side of payroll taxes.
- A second return. The business files Form 1120-S by March 15 (September 15 on extension) and issues a Schedule K-1 to each owner, who reports it on Form 1040. Arizona requires Form 120S as well.
- Retirement contributions change. Employer contributions to a Solo 401(k) or SEP are based on W-2 wages rather than total profit, so a low salary can shrink the room for contributions.
- Health insurance moves to payroll. Premiums for an owner with more than 2% of the company run through the W-2 and remain deductible, but the mechanics are stricter.
- The qualified business income deduction interacts with salary. Wages reduce the income the deduction is calculated on, and at higher incomes W-2 wages can help you keep the deduction. This cuts both ways and belongs in the projection.
The reasonable salary rule
The IRS requires shareholder-employees to receive reasonable compensation before taking distributions. There is no published number. The test looks at what you do, how much time you spend, what comparable businesses pay for that work, and your training and experience. Paying yourself a token salary and taking everything else as distributions is the most common way an S corporation draws scrutiny, and a reclassification comes with back payroll taxes and penalties.
A defensible salary is documented: the role, the hours, the comparison data you used, and when you reviewed it. We set it in writing when the election is made and revisit it each year.
When the math tends to work
A common rule of thumb says the election starts to pay once a business consistently nets more than roughly $40,000 to $50,000 a year after expenses. Treat that as a starting point, not an answer. Whether it works for you depends on how much of the profit a reasonable salary absorbs, what payroll will cost, how much you want to contribute to retirement, your state taxes, and whether the profit is steady. A business that nets $60,000 with a $55,000 reasonable salary gains little. A business that nets $150,000 with a $70,000 reasonable salary usually has a clear case.
Who can elect
- A domestic entity with no more than 100 owners.
- Owners must be individuals, certain trusts, or estates. Other companies, partnerships and nonresident aliens cannot own shares.
- One class of stock. For an LLC this means the operating agreement cannot allocate profits or distributions out of proportion to ownership. Agreements written for a partnership often need amending before the election.
Deadlines for Form 2553
The election is made on Form 2553. For it to take effect for the current tax year, the form is due no later than two months and 15 days after the start of that year, which is March 15 for a calendar-year business. A new business has two months and 15 days from the start of its first tax year. File later and the election normally begins the following year.
The IRS grants late-election relief when the delay has a reasonable cause, generally if you file within three years and 75 days of the intended start date and the business has reported consistently as an S corporation in the meantime. Once made, the election stays in place until it is revoked or terminated. Revoking requires owners holding more than half the company to agree, and a business that revokes generally cannot elect again for five years without IRS consent.
Arizona notes
Arizona follows the federal election. The business files Arizona Form 120S and the owners report the pass-through income on their Arizona returns. Arizona also lets pass-through entities elect to pay state income tax at the entity level, which can help owners affected by the federal limit on deducting state and local taxes. Whether that election helps depends on your other deductions, so it goes into the same projection.
Multi-member LLCs
A multi-member LLC can elect as well. The rules are the same, with one practical difference: distributions must follow ownership percentages exactly, every time. Partnerships that split profits differently from ownership, or that bring in new partners with special allocations, usually do better staying taxed as partnerships. Our guide to Form 1120-S versus Form 1065 walks through those differences.
How we decide
We run a side-by-side projection: your current structure against an S corporation with a documented reasonable salary, including payroll costs, state taxes, retirement goals and the qualified business income deduction. If the election fits, we handle Form 2553, coordinate the payroll setup, and build the quarterly plan around it. If it does not, you keep the simpler structure and we revisit when the numbers change.
Book a Discovery Call if you want the projection run on your actual numbers.
This guide is general information for small business owners, not advice for your specific situation. Tax law changes and the details matter, so talk with a professional before acting.
Sources: IRS, About Form 2553 · IRS, S corporations · IRS, About Form 1120-S