Entity Selection: Sole Prop vs. LLC vs. S-Corp
Forming an LLC changes nothing about your tax bill. That surprises almost everyone who forms one for tax reasons — the lever that actually moves self-employment tax is a separate election most people have never heard of.
Legal structure and tax structure are different questions
An LLC is a legal entity. It separates your business liabilities from your personal assets, which is a genuine and worthwhile protection, and it changes your federal income tax by nothing at all. A single-member LLC is disregarded for tax purposes: you file the same Schedule C you filed before.
What does move the tax is self-employment tax — 15.3% covering both halves of Social Security and Medicare, which an employer would otherwise split with you. It applies to 92.35% of net profit, and only the 12.4% Social Security half stops at the annual wage base. The 2.9% Medicare half runs on every dollar, with an extra 0.9% above high-income thresholds.
The lever is an S-Corp election, which an LLC can make. It is a tax election, not a different legal entity — which is why 'should I form an LLC?' and 'should I elect S-Corp treatment?' are two separate decisions that get collapsed into one.
LLC = liability protection, no tax change. S-Corp election = the tax change, available to an LLC.
The word carrying all the weight is 'reasonable'
Under an S-Corp election you pay yourself a W-2 salary, which carries payroll tax, and take the remaining profit as a distribution, which does not. The obvious move is to set the salary very low and the distribution very high, and the obvious move is exactly what the IRS examines.
The salary must be reasonable compensation for the work you actually do — benchmarked against what someone would be paid to do that job. An owner generating $150,000 of profit who pays themselves $20,000 is inviting recharacterisation of the distributions as wages, with back taxes and penalties attached.
The election also isn't free: payroll, employment tax returns and a separate corporate return, which usually means paying an accountant. Below roughly the mid five figures of profit that overhead eats the saving, which makes this a threshold decision rather than a universal upgrade.
Sole props and single-member LLCs pay SE tax on 92.35% of net profit. An S-Corp election splits profit into W-2 salary, which is taxed, and distributions, which aren't — but the salary has to be defensibly reasonable and the election carries real overhead.
Sources
- Publication 334: Tax Guide for Small Business — Internal Revenue Service (2026)