If you've spent any time around small business owners, you've probably heard the same advice repeated over and over:
"You should form an LLC."
Or perhaps:
"You need to become an S corporation to save on taxes."
The problem is that neither statement is universally true.
One of the most common tax planning mistakes business owners make is assuming there is a single "best" business structure. In reality, choosing between an LLC and an S corporation depends on your income level, self-employment tax exposure, Qualified Business Income (QBI) deduction, payroll obligations, retirement goals, administrative costs, and long-term business plans.
So which is better for taxes in 2026: an LLC or an S corporation?
The answer depends on your specific circumstances.
First, Understand the Difference
Before comparing taxes, it's important to understand that an LLC and an S corporation are not actually opposites.
An LLC (Limited Liability Company) is a legal entity formed under state law.
An S corporation is a federal tax election made with the IRS.
In fact, many S corporations begin as LLCs and then elect S corporation tax treatment by filing IRS Form 2553.
This distinction is important because simply forming an LLC does not automatically change how your business is taxed.
How an LLC Is Taxed
By default:
- A single-member LLC is taxed as a sole proprietorship.
- A multi-member LLC is taxed as a partnership.
In both cases, business income generally passes through to the owner's personal tax return.
For many business owners, this creates a straightforward tax structure with minimal administrative requirements.
Advantages of LLC Taxation
- Simple to establish and maintain
- Minimal compliance requirements
- No payroll requirements for owners
- Easier bookkeeping and recordkeeping
- Direct access to self-employed health insurance deductions
- Potential eligibility for the Qualified Business Income (QBI) deduction
Disadvantages of LLC Taxation
The biggest drawback is self-employment tax.
Generally, all net business income is subject to:
- Social Security tax
- Medicare tax
Combined, these taxes can significantly increase the overall tax burden for profitable businesses.
How an S Corporation Is Taxed
An S corporation remains a pass-through entity, meaning profits generally flow through to the shareholder's personal tax return.
However, there is one major difference.
The owner is required to pay themselves a reasonable salary for services performed.
That salary is subject to payroll taxes.
Any remaining profit can generally be distributed to the owner without additional self-employment tax.
This creates the primary tax advantage of an S corporation.
Why S Corporations Can Reduce Taxes
Consider a business generating $150,000 of profit.
Under a sole proprietorship or default LLC structure:
- The full amount may be subject to self-employment tax.
Under an S corporation:
- The owner might receive a reasonable salary.
- Remaining profits pass through as business income.
This can reduce Social Security and Medicare taxes on a portion of the earnings.
For some businesses, the savings can be substantial.
The QBI Deduction Changes Everything
Prior to the Tax Cuts and Jobs Act (TCJA), many tax professionals automatically recommended S corporation elections once profits reached certain levels.
Today, the analysis is more complicated.
The Qualified Business Income (QBI) deduction allows eligible business owners to deduct up to 20% of qualified business income.
Here's where things get interesting:
When an S corporation pays shareholder wages, those wages reduce QBI.
As a result:
- Lower wages may increase QBI.
- Higher wages may reduce QBI.
This means the traditional "always elect S corporation status" advice may no longer produce the best overall tax outcome.
In some situations, remaining a sole proprietor or default-taxed LLC can actually generate a lower total tax burden after considering both self-employment taxes and the QBI deduction.
The Hidden Cost of S Corporations
Many business owners focus only on tax savings.
However, S corporations introduce additional requirements:
Payroll
Owners generally must run payroll and issue W-2 wages.
Reasonable Compensation
The IRS requires shareholder-employees to receive reasonable compensation.
There is no official formula.
The IRS considers factors such as:
- Duties performed
- Experience
- Industry standards
- Time devoted to the business
- Comparable compensation
Additional Compliance Costs
S corporations often require:
- Payroll services
- Corporate tax returns
- Corporate recordkeeping
- Separate accounting procedures
These costs can reduce or eliminate projected tax savings for smaller businesses.
Common Myth: The 60/40 Rule
Many business owners have heard that an S corporation owner should take:
- 60% salary
- 40% distributions
This is a myth.
The IRS has never approved a universal percentage rule.
Reasonable compensation must be based on the facts and circumstances of each business.
A salary that is appropriate for one business may be completely inappropriate for another.
When an LLC May Be Better Than an S Corporation
An LLC taxed as a sole proprietorship may be preferable when:
- Business income is relatively modest
- Administrative simplicity is important
- The QBI deduction creates significant tax benefits
- Payroll costs outweigh projected savings
- Retirement contribution calculations favor sole proprietor treatment
When an S Corporation May Be Better Than an LLC
An S corporation may be beneficial when:
- Business profits consistently exceed reasonable compensation levels
- Self-employment taxes are becoming significant
- The owner is willing to maintain payroll compliance
- Tax savings exceed additional administrative costs
The Bottom Line
The question isn't whether an LLC or an S corporation is better.
The real question is:
Which structure produces the best overall tax outcome for your specific situation?
For some businesses, the answer will be an LLC taxed as a sole proprietorship. For others, an S corporation election may generate meaningful self-employment tax savings. In certain situations, partnerships or even C corporations may deserve consideration as well.
The most effective entity selection decisions are based on a full analysis of taxes, business goals, compliance requirements, growth plans, and long-term strategy—not one-size-fits-all advice.
Learn More About Entity Selection
Choosing between an LLC and an S corporation is rarely as simple as following a rule of thumb. Tax professionals must evaluate self-employment taxes, payroll requirements, QBI deductions, retirement planning opportunities, reasonable compensation rules, compliance costs, and long-term business objectives before making recommendations.
If you want a deeper understanding of how entity selection affects real-world tax outcomes, consider the 2026 Entity Selection: Which One Should I Choose? course with Jason Dinesen, EA.
Through detailed information, tax comparisons, and practical planning scenarios, you'll learn:
- How sole proprietorships, partnerships, LLCs, S corporations, and C corporations are taxed
- When an S corporation election may provide tax savings
- How the QBI deduction affects entity planning decisions
- Common reasonable compensation mistakes and IRS scrutiny risks
- Situations where C corporations may offer advantages
- The role attorneys and tax professionals play in entity selection planning
Whether you advise small business owners, freelancers, consultants, independent contractors, or growing companies, this course provides practical insights you can immediately apply to client situations.
External Resources
- IRS Form 2553 Instructions
- IRS S Corporation Compensation Guidance
- IRS Qualified Business Income Deduction Information
- IRS Limited Liability Company Information
- IRS Self-Employment Tax Information
Frequently Asked Questions
Is an LLC or an S corporation better for taxes?
Neither is automatically better. The best choice depends on profit levels, self-employment taxes, QBI deductions, payroll requirements, compliance costs, and long-term business goals.
Does an LLC automatically save taxes?
No. An LLC is a legal structure, not a tax classification. Tax savings depend on how the business is taxed for federal income tax purposes.
Can an LLC elect S corporation status?
Yes. Many LLCs elect S corporation taxation by filing Form 2553 with the IRS.
What is the biggest tax benefit of an S corporation?
The potential reduction of self-employment taxes on a portion of business profits.
Does every business owner need an S corporation?
No. Many businesses benefit from remaining sole proprietorships or default-taxed LLCs. The decision should be based on a comprehensive tax analysis.
What is reasonable compensation?
Reasonable compensation is the salary an S corporation owner must receive for services provided to the business. The IRS evaluates multiple factors rather than using a fixed percentage.
Where can I learn more about LLCs, S corporations, and entity selection?
Tax professionals who want a deeper understanding of entity planning strategies can explore the 2026 Entity Selection: Which One Should I Choose? course with Jason Dinesen, EA. The course examines sole proprietorships, partnerships, LLCs, S corporations, and C corporations through real-world examples and case studies, helping practitioners evaluate the tax consequences of different entity structures.
