Should I Start an LLC or S-Corp? A Clear Guide to Choosing the Right Structure

You’re ready to make your business official, but you’ve hit a wall trying to figure out whether to start an LLC or S-Corp. You’ve seen both terms everywhere, read conflicting advice, and maybe even had well-meaning friends tell you opposite things. Here’s what makes this decision so confusing: most people don’t realize that LLC and S-Corp aren’t actually competing choices, they’re two different things entirely.

An LLC is a legal business structure you form with your state. An S-Corp is a tax classification you elect with the IRS. You can actually have both at the same time. Understanding this fundamental difference changes everything about how you approach this decision.

This guide will walk you through the real differences between operating as a standard LLC and electing S-Corp tax treatment. We’ll explain how each affects your taxes, what compliance requirements you’ll face, and which scenarios favor each approach. By the end, you’ll have a clear framework for making the right choice for your specific situation.

The Difference Most People Miss: Entity vs. Tax Status

Let’s clear up the biggest source of confusion right away. When you form an LLC (Limited Liability Company), you’re creating a legal entity recognized by your state. This entity provides liability protection, separating your personal assets from your business debts and obligations. It’s a structure that exists in the eyes of the law.

An S-Corp, on the other hand, isn’t a business structure at all. It’s a tax election defined by Subchapter S of the Internal Revenue Code. When people say they “formed an S-Corp,” what they actually did was form a corporation (or LLC) and then filed IRS Form 2553 to elect S-Corp tax treatment.

This means you don’t have to choose between forming an LLC or becoming an S-Corp. You can form an LLC and then elect to be taxed as an S-Corp. Many successful businesses do exactly this: they get the operational flexibility and simplicity of an LLC structure while taking advantage of S-Corp tax benefits when their income reaches the right level.

When you first form an LLC, the IRS assigns it a default tax classification. If you’re the only owner, your LLC is automatically taxed as a sole proprietorship. If you have multiple members, it’s taxed as a partnership. In both cases, the LLC itself doesn’t pay federal income taxes; profits and losses pass through to your personal tax return.

But you’re not stuck with this default treatment. At any point after formation, you can elect to have your LLC taxed as an S-Corp instead through the S-Corp election process. You can also elect C-Corp taxation, though that’s less common for small businesses due to double taxation concerns. The key insight is that your legal structure (LLC) and your tax classification (sole proprietorship, partnership, S-Corp, or C-Corp) are separate decisions.

This flexibility is one of the LLC’s greatest advantages. You can start simple with default taxation and change your tax treatment later as your business grows and your situation evolves. You don’t need to predict your future perfectly when you’re just getting started.

How LLCs and S-Corps Handle Taxes Differently

Both standard LLCs and S-Corps use pass-through taxation, meaning business income flows through to your personal tax return rather than being taxed at the business level. This avoids the double taxation that C-Corps face. But the way you pay taxes on that income differs significantly between the two approaches.

With a standard LLC taxed as a sole proprietorship or partnership, all business profits are subject to self-employment tax. This covers Social Security and Medicare contributions, currently totaling 15.3% on income up to the Social Security wage base. If your LLC generates $80,000 in profit, you’ll pay self-employment tax on the entire $80,000, plus regular income tax.

When you elect S-Corp taxation, the IRS requires you to pay yourself a reasonable salary for the work you do in the business. This salary goes through payroll, with proper withholding for Social Security, Medicare, and income taxes. Here’s where it gets interesting: any remaining profits after your salary can be distributed to you as dividends, which aren’t subject to self-employment tax.

Let’s say your business generates that same $80,000 in profit. With S-Corp taxation, you might pay yourself a $50,000 salary (which must be reasonable for your industry and role). That $50,000 gets hit with payroll taxes. But the remaining $30,000 in profit can be distributed to you as dividends, avoiding the 15.3% self-employment tax. That’s a potential savings of $4,590 on just that $30,000.

The catch is that “reasonable salary” requirement. You can’t pay yourself $20,000 and take $60,000 in dividends if comparable positions in your industry earn $55,000. The IRS scrutinizes S-Corp salary levels specifically to prevent abuse of this tax benefit. Setting your salary too low can trigger audits and penalties.

This is why the S-Corp election typically makes financial sense only when your business profits consistently exceed what you’d need to pay yourself as a reasonable salary. If your business generates $40,000 in profit and you’d need to pay yourself most of that as salary anyway, the tax savings probably don’t justify the additional compliance costs of S-Corp treatment.

Most tax professionals suggest considering S-Corp election when your business profits exceed $60,000 to $80,000 annually, though the exact threshold depends on your specific circumstances, industry salary norms, and state tax considerations. The savings need to outweigh the costs of running payroll and maintaining S-Corp compliance.

Ownership Rules and Flexibility: Which Structure Fits Your Plans?

LLCs offer remarkable flexibility when it comes to ownership structure. You can have unlimited members, include foreign investors, create different classes of membership with varying rights and profit distributions, and bring on new partners without restructuring your entire business. This flexibility makes LLCs ideal for businesses with complex ownership needs or uncertain growth trajectories.

S-Corp taxation, however, comes with strict IRS restrictions. You’re limited to 100 shareholders maximum. Every shareholder must be a U.S. citizen or resident alien; no foreign investors allowed. You can only have one class of stock, meaning every share must have identical rights to distributions and liquidation proceeds. Certain entities, like other corporations and partnerships, can’t be shareholders.

These restrictions might seem arbitrary, but they reflect the S-Corp’s origins as a tax benefit designed for small, closely-held domestic businesses. The IRS wants to prevent large corporations or complex ownership structures from accessing S-Corp tax treatment.

If you’re planning to bring on venture capital investors, the S-Corp election probably won’t work. Most VC firms are structured as partnerships or have foreign investors, disqualifying them from S-Corp ownership. If you’re building a tech startup with plans for significant outside investment, you’ll likely need to stick with standard LLC taxation or consider a conversion to a C-Corp down the road.

Real estate investors often prefer standard LLC treatment for similar reasons. They might want to bring in foreign investors, create preferred and common membership classes with different profit distributions, or structure complex waterfall arrangements. The S-Corp’s single class of stock restriction makes these strategies impossible.

On the other hand, if you’re running a professional services firm, local retail business, or consulting practice with a small number of U.S.-based owners, the S-Corp restrictions probably won’t affect you. The ownership flexibility you’re giving up might not matter for your particular business model.

Think about your five-year plan. Will you need to raise money from institutional investors? Do you want the option to bring in international partners? Are you planning to offer different types of ownership stakes to different contributors? Your answers to these questions should heavily influence whether S-Corp taxation makes sense for your situation.

Compliance and Paperwork: What Each Structure Requires

Standard LLCs are relatively straightforward to maintain. You’ll need an operating agreement that outlines how your business will be run, though this document typically stays internal unless a bank or investor requests it. Most states require annual reports with basic information updates and a filing fee. Beyond that, your compliance obligations are minimal.

LLCs don’t require formal meetings, corporate minutes, or extensive record-keeping beyond standard business bookkeeping. You have flexibility in how you structure management and make decisions. This simplicity is one reason LLCs have become the default choice for small businesses.

Electing S-Corp taxation adds several layers of compliance requirements. First, you must run payroll for yourself and any employee-owners, which means setting up payroll processing, making quarterly payroll tax deposits, filing quarterly Form 941 reports with the IRS, and issuing W-2s at year-end. Even if you’re the only employee, you need proper payroll systems in place.

S-Corps require more rigorous record-keeping and corporate formalities. You should hold annual shareholder meetings, maintain meeting minutes, document major business decisions, and keep a clear separation between business and personal finances. While the IRS doesn’t audit these formalities directly, maintaining them protects your liability shield and demonstrates that you’re treating the S-Corp election seriously.

Your tax filings become more complex with S-Corp treatment. In addition to your personal return, you’ll file Form 1120-S (the S-Corp tax return) and issue K-1 forms to all shareholders showing their share of income, deductions, and credits. Many business owners need to hire accountants or tax professionals to handle S-Corp filings properly, adding to the annual cost.

The ongoing costs add up quickly. Payroll processing services typically charge $40 to $150 per month. Accounting fees for S-Corp tax preparation often run $800 to $2,000 annually, compared to $300 to $800 for standard LLC returns. You might spend $1,500 to $3,000 per year on additional compliance costs related to S-Corp treatment.

These costs aren’t prohibitive if your tax savings exceed them by a comfortable margin. But for newer businesses or those with modest profits, the compliance burden can outweigh the benefits. This is why many businesses wait to elect S-Corp treatment until their income clearly justifies the additional complexity.

Which Choice Makes Sense for Your Business?

Standard LLC taxation typically works best for businesses in their early stages. When you’re just starting out, your profits might not be high enough to generate meaningful S-Corp tax savings. The simpler compliance requirements let you focus on building your business rather than managing payroll and corporate formalities.

Side hustles and part-time businesses usually benefit from staying with standard LLC treatment. If you’re earning $20,000 to $40,000 annually from a business you run alongside your day job, the S-Corp’s reasonable salary requirement would eat up most of your profits anyway. The additional paperwork isn’t worth it at that income level.

Real estate holding companies often stick with standard LLCs due to the ownership flexibility benefits. Investors frequently want to structure different profit distributions for different partners, bring in foreign investors, or create preferred returns for certain members. These arrangements don’t work under the S-Corp’s single class of stock restriction.

Businesses planning to raise institutional investment should generally avoid the S-Corp election. The restrictions on foreign investors and entity shareholders disqualify most venture capital firms and many angel investors. You’d likely need to convert back to standard taxation or C-Corp treatment before raising significant outside capital.

S-Corp taxation starts making sense for established businesses generating consistent profits above owner salary needs. If you’re running a profitable consulting practice, professional services firm, or established small business where you’re taking home $80,000 or more annually, the self-employment tax savings can be substantial.

Service-based businesses with high profit margins relative to labor costs often benefit most from an S-Corp election. If you’re a consultant billing $150,000 annually with minimal expenses, you might pay yourself a $70,000 salary and take $80,000 in distributions. The tax savings on that $80,000 could exceed $12,000 annually, easily justifying the compliance costs.

Ask yourself these questions: What are my current annual profits, and what do I reasonably expect them to be next year? Would I be comfortable paying myself a reasonable salary and still have significant profits left over? Am I organized enough to handle payroll, quarterly filings, and more complex record-keeping? Do I have plans to bring in investors who might not qualify for S-Corp ownership?

Your tolerance for administrative tasks matters too. Some business owners don’t mind the additional paperwork and see it as part of running a professional operation. Others would rather keep things simple and focus entirely on their core business activities. Neither approach is wrong; it’s about what works for your personality and situation.

Remember that this isn’t a permanent, irreversible decision. Many successful businesses start as standard LLCs and elect S-Corp taxation once their income reaches the point where it makes financial sense. You can always change your tax treatment as your circumstances evolve.

Making Your Decision With Confidence

There’s no universal right answer to whether you should start an LLC or elect S-Corp taxation; the best choice depends entirely on your specific circumstances. Your current income level, growth plans, ownership structure needs, and willingness to handle additional compliance all factor into the decision.

For most new businesses, starting with a standard LLC provides the liability protection you need with minimal administrative burden. You can focus on building your business, establishing consistent revenue, and understanding your actual profit patterns. Once your income reaches levels where S-Corp tax savings become meaningful, you can elect that treatment by filing a simple form with the IRS.

This staged approach lets you start simple and add complexity only when it provides clear financial benefits. You’re not locked into your initial choice forever. Business structures can evolve as your needs change.

The most important step is getting your business properly formed and protected. Whether you start with standard LLC taxation or elect S-Corp treatment from day one, having the right legal structure in place protects your personal assets and establishes your business as a legitimate entity.

If you’re ready to move forward with forming your LLC, vState Filings can guide you through the entire process. We handle entity formation services across all 50 states, ensuring your paperwork is filed correctly and your business is set up properly from the start. Contact vState Filings to learn more about our services and take the first step toward making your business official.