Your self-employed clients will ask this question. Having a clear, accurate answer ready positions you as a knowledgeable practitioner.
Clearing Up the Confusion
An LLC is a state-level entity structure. An S-Corp is a federal tax election. They’re not mutually exclusive. Most small business S-Corps are actually LLCs that elected S-Corp tax treatment by filing Form 2553 with the IRS. The question isn’t “LLC or S-Corp.” It’s “should my LLC be taxed as a sole proprietorship or should it elect S-Corp status?”
Why It Matters
When a sole proprietor or single-member LLC earns $150,000 in net profit, they pay self-employment tax on the entire amount. That’s 15.3% on the first portion (up to the Social Security wage base) and 2.9% above it. Depending on the numbers, that can exceed $20,000 in self-employment tax alone.
With an S-Corp election, the owner pays themselves a reasonable salary (say $70,000) and takes the remaining $80,000 as a distribution. Payroll taxes apply to the salary but not the distribution. The savings can be $10,000 to $15,000 or more per year.
The Tradeoffs
The S-Corp requires payroll processing, quarterly payroll tax filings, W-2s, and its own tax return (Form 1120-S), which costs more to prepare than a Schedule C. The IRS also scrutinizes “reasonable compensation.” If the owner pays themselves too little salary to avoid payroll taxes, the IRS can reclassify distributions as wages and assess back taxes, penalties, and interest.
The Rule of Thumb
The S-Corp election generally makes financial sense when net self-employment income consistently exceeds $40,000 to $60,000 per year. Below that, the payroll and filing costs eat up the savings.
Your Role
You can explain the general tradeoffs, run rough projections, and help the client understand their options. When the client is ready to make the election, refer them to an attorney or CPA who can handle the filing and ensure it’s done properly.
Knowing enough to have this conversation is what separates a good preparer from someone who just fills in boxes.
For in-depth training on entity selection conversations and advisory services, visit musespring.com.