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Sole proprietor, LLC or S corporation: how the choice affects a self-employed person’s taxes

An LLC is a legal wrapper; it doesn’t change your federal tax on its own. An S corporation election does — mainly by splitting your profit into salary and distributions — and it brings costs and rules that decide whether it’s worth it.

Last reviewed September 2026 · General information, not advice for your situation

In short

Two separate questions: the legal form and the tax classification

People often talk about “an LLC or an S corp” as if they were alternatives. They aren’t quite. A limited liability company is a legal entity created under state law — it’s mainly about liability and how the business is owned and run. How that entity is taxed is a separate, federal question with its own rules.

Under the IRS “check-the-box” regulations, an LLC with one owner is by default disregarded as an entity separate from its owner. For income tax, the IRS sees only the owner. An individual owner of a non-farm business reports it on Schedule C of their personal return, the same way a sole proprietor with no entity at all does (IRS Publication 334, ch. 1, “Limited liability company (LLC)”); farming goes on Schedule F and some rental activity on Schedule E (Schedule C instructions, “Single-member limited liability company (LLC)”).

The disregarded treatment doesn’t extend to employment taxes. A single-member LLC with employees files its employment tax returns under the LLC’s own name and employer identification number (Schedule C instructions, “Single-member LLCs with employees”).

That same LLC can instead elect to be taxed as an S corporation by filing Form 2553. The Form 2553 instructions (“Purpose of Form”) explain that an eligible entity making a timely S election is treated as a corporation from the election’s effective date and doesn’t need to file a separate Form 8832. So the real choice for most self-employed people is: taxed as a sole proprietor (with or without an LLC) or taxed as an S corporation (usually an LLC or a corporation that has made the election).

Forming an LLC can matter for liability, contracts and banking, and your state may charge fees or taxes for it. Those are real considerations, but they’re outside this guide, which is about federal income and employment tax.

How a sole proprietor is taxed: self-employment tax

A sole proprietor (including a single-member LLC that hasn’t elected otherwise) pays two taxes on business profit: ordinary income tax, and self-employment tax — the self-employed version of the Social Security and Medicare taxes an employer and employee would split.

  • Rates. 12.4% for Social Security and 2.9% for Medicare, 15.3% in total (IRC §1401).
  • The base. The tax isn’t charged on 100% of profit. The law first reduces net earnings by half of those rates, so the tax applies to 92.35% of net profit (IRC §1402(a)(12)).
  • The Social Security cap. The 12.4% part stops at a cap that is set for each year: $176,100 for 2025 (Schedule SE instructions (2025), “What’s New”) and $184,500 for 2026 (IRS Topic 751). The 2.9% Medicare part has no cap (IRS Topic 751). Someone who also earns W-2 wages has the cap on self-employment income reduced by those wages (IRC §1402(b)(1)).
  • Additional Medicare Tax. A further 0.9% applies to earnings above $200,000 ($250,000 married filing jointly, $125,000 married filing separately). These thresholds are fixed in the statute (IRC §1401(b)(2)) and aren’t indexed for inflation (IRS Topic 560). For someone with both wages and self-employment income, the threshold is reduced by the wages before it is applied to the self-employment income (IRS, “Questions and answers for the Additional Medicare Tax”).
  • A deduction for half. You deduct half of your self-employment tax (other than the 0.9% Additional Medicare Tax) in figuring income tax (IRC §164(f)).
  • Small amounts. No self-employment tax is due if net earnings from self-employment are under $400 for the year, an amount fixed in the statute (IRC §1402(b)(2)).

An illustration using 2026 figures: net profit of $100,000 gives self-employment earnings of $92,350 (92.35%). Self-employment tax at 15.3% is $14,129.55, before any income tax. This is purely to show the mechanics; actual figures depend on everything else on a return.

What an S corporation election changes

An S corporation doesn’t usually pay federal income tax itself: its income generally is taxed to its shareholders (Form 2553 instructions, “Purpose of Form”), and each shareholder’s share is reported on a Schedule K-1 (Form 1120-S instructions). The difference that draws self-employed people to it is how that profit is treated for Social Security and Medicare.

  • An owner who works in the business is generally its employee. An officer who performs substantial services for the corporation and is paid in any form for them is an employee; an officer who performs only minor services and receives no pay is not (IRS Information Letter 2003-0026, p. 2). An owner-employee is paid a salary through payroll, and Social Security and Medicare are withheld and paid on it, like any other employee’s wages.
  • Profit above the salary passes through without those taxes. The Form 1120-S instructions state that S corporation income isn’t self-employment income and isn’t subject to self-employment tax (Form 1120-S instructions, General Instructions). The position goes back to Rev. Rul. 59-221, described in IRS Information Letter 2003-0026, p. 1 (an information letter is advisory only). The income is still subject to income tax.

So the potential saving is the Social Security and Medicare tax on the part of the profit that is not salary. That makes the salary figure the heart of the whole arrangement.

Reasonable compensation: the rule that limits the saving

An owner-employee can’t set their salary at zero and take everything as distributions. In the IRS’s words, S corporations must pay reasonable compensation to a shareholder-employee for the services they provide before non-wage distributions may be made — and the IRS can reclassify distributions as wages when it isn’t.

No statute sets a salary percentage. The IRS lists factors it considers — including training and experience, duties, time devoted to the business, what comparable businesses pay for similar services, compensation agreements, and the use of a formula to determine compensation — and says the key is what the shareholder-employee did for the corporation, looked at through the source of its gross receipts: the owner’s personal services, other employees, or capital and equipment (IRS, “Some factors in determining reasonable compensation”). In a one-person service business where the profit is essentially the owner’s labor, a reasonable salary may be a large share of it, which leaves little to save.

Rules of thumb you may hear — a fixed dollar amount of profit at which an S corporation “pays for itself”, or a 60/40 salary split — don’t appear in the IRS’s list of reasonable-compensation factors (IRS). The salary turns on the facts of each business.

The costs and side effects of an S corporation

The Social Security and Medicare saving has to be weighed against things that don’t exist for a sole proprietor:

  • Payroll. Paying yourself wages means withholding, quarterly Form 941 returns (or an annual Form 944 for an employer the IRS has notified to file one) (Form 941 instructions, “Who Must File”), year-end W-2s, and state payroll and unemployment filings — usually through a payroll service.
  • A separate return. The S corporation files its own return, Form 1120-S, and issues each owner a K-1, in addition to the owner’s personal return (Form 1120-S instructions, “Who Must File”).
  • The QBI deduction can shrink. The qualified business income deduction is generally up to 20% of qualified business income (IRC §199A(b)(2)(A)), and in total can’t exceed 20% of taxable income minus net capital gain (IRC §199A(a)). For a sole proprietor, that’s the whole profit (after certain adjustments). For an S corporation owner, the reasonable salary is not qualified business income (§199A(c)(4)), so moving profit into salary reduces the deduction’s base. For higher incomes the deduction also has limits based on the business’s W-2 wages and on “specified service” businesses; for 2026 those begin above taxable income of $201,750 for single, head of household and other filers ($403,500 married filing jointly; $201,775 married filing separately) and are fully phased in at $276,750 ($553,500 married filing jointly; $276,775 married filing separately) (Rev. Proc. 2025-32 §4.26).
  • Retirement contributions follow wages. For a sole proprietor, contributions to plans like a SEP or solo 401(k) are based on net earnings from self-employment. S corporation income passed through to shareholders isn’t net earnings from self-employment (Publication 560, ch. 1, “Net earnings from self-employment”), and an employee’s compensation for plan purposes is the pay received for personal services (Publication 560, “Compensation”), so an S corporation owner’s contributions are based on their W-2 salary. A low salary can mean a lower contribution limit.
  • Health insurance is handled differently. For an owner of more than 2%, premiums the S corporation pays are included in W-2 wages (though not subject to Social Security and Medicare if paid under a qualifying plan), and the owner may then deduct them on their personal return if the conditions are met (IRS, “Treating medical insurance premiums as wages”).
  • Losses are limited to basis. A shareholder can deduct S corporation losses only up to their basis in their stock and in loans they’ve made directly to the corporation; the excess carries forward (IRC §1366(d)(1)–(2)). Personally guaranteeing a bank loan to the corporation doesn’t, by itself, give basis (Treas. Reg. §1.1366-2(a)(2)(ii)). The at-risk rules (IRC §465) and passive-activity rules (IRC §469) can limit losses further.
  • Taking property out can be taxable. If an S corporation distributes property worth more than its tax basis — equipment, a vehicle, real estate — it’s treated as having sold it at fair market value (IRC §311(b), applied to S corporations by §1371), and that gain passes through to the owners.
  • Eligibility. An S corporation can have no more than 100 shareholders and only one class of stock, and generally only individuals (plus certain trusts and estates) who aren’t nonresident aliens can own it (IRC §1361(b)). An election ends when the corporation stops meeting these conditions — for example, if a corporate or nonresident-alien owner acquires shares (IRC §1362(d)(2)).

State and city rules don’t always follow

The federal election doesn’t automatically carry through to every state and city. Three examples:

  • New York City taxes S corporations under its General Corporation Tax. NYC Finance states that the city does not have an S corporation election and does not recognize the New York State election.
  • New York State requires a separate election, Form CT-6, with all shareholders consenting, for the corporation to be treated as a New York S corporation (CT-6 instructions). A federal S corporation that doesn’t make the election is treated as having made it anyway if its investment income is more than 50% of its federal gross income (CT-3-S instructions, “Mandated New York S corporation”).
  • New Jersey no longer requires a separate election for privilege periods beginning on or after December 22, 2022, but it has its own conditions — including registration and a shareholder consent — and a corporation can choose to be taxed as a C corporation in New Jersey instead (NJ Technical Bulletin TB-105(R)).

Other states have their own rules, fees and minimum taxes, which can change the result of the comparison.

Timing the election

For the election to apply from the start of a tax year, Form 2553 generally has to be filed no more than 2 months and 15 days after the beginning of that year, or at any time during the year before (IRC §1362(b); Form 2553 instructions). For a calendar-year business, that’s by March 15 for the election to cover the whole year. For a brand-new business, the first tax year is treated as beginning on the earliest of the date it first had shareholders, first had assets, or began doing business (Form 2553 instructions, Item E), so the deadline runs from that date.

An election filed late isn’t necessarily lost. The Form 2553 instructions (“Relief for Late Elections”) describe relief under Rev. Proc. 2013-30 for an election filed within 3 years and 75 days of its intended effective date — and in some cases later — where there was reasonable cause and the conditions are met, including consent statements from all shareholders.

Putting it together

Whether an S corporation makes sense comes down to a comparison that has to be done with real figures: the Social Security and Medicare tax saved on profit above a defensible salary, against the cost of payroll and a second return, any state or city tax, a possibly smaller QBI deduction, and changes to retirement contributions and health insurance. For some businesses the saving is clear. For others — lower profit, profit that is almost all the owner’s own labor, or a location such as New York City that doesn’t recognize the election (NYC Finance) — it can be small or negative.

Income can change from year to year, so a comparison based on a single year shows only part of the picture. Undoing an election has its own rules: a revocation needs the consent of shareholders holding more than half the shares (IRC §1362(d)(1)(B)), and after an election ends, the corporation generally can’t elect again before its fifth tax year after the termination without IRS consent (IRC §1362(g)).

Common questions

Does forming an LLC lower my taxes?

Not by itself. A single-member LLC is disregarded for federal income tax by default (Treas. Reg. §301.7701-3(b)(1)(ii)), so a non-farm business’s profit goes on the owner’s Schedule C (or Schedule E or F, where those apply) and is subject to self-employment tax as it would be without the LLC (Schedule C instructions, “Single-member limited liability company (LLC)”). The LLC does file employment tax returns under its own EIN if it has employees (Schedule C instructions, “Single-member LLCs with employees”). Its federal income tax treatment changes only if it elects to be taxed differently, for example as an S corporation (Form 2553 instructions).

What salary do I have to pay myself from an S corporation?

Reasonable compensation for the services the shareholder-employee provides, paid before non-wage distributions (IRS, “Reasonable compensation”). No statute sets a percentage. The IRS weighs factors such as duties, time devoted, experience, what comparable businesses pay, compensation agreements and any formula used (IRS, “Some factors in determining reasonable compensation”), and it can reclassify distributions as wages.

What is the deadline to elect S corporation status?

For the election to apply to a tax year, Form 2553 is generally due no more than 2 months and 15 days after the start of that year (March 15 for a calendar year), or any time in the prior year (Form 2553 instructions, “When To Make the Election”; IRC §1362(b)(1)). Relief for a late election may be available under Rev. Proc. 2013-30 when its conditions are met (Form 2553 instructions, “Relief for Late Elections”).

Is the QBI deduction still available after 2025?

Yes. The 2025 law commonly known as the One, Big, Beautiful Bill Act, Public Law 119-21 (Rev. Proc. 2025-32 §1), removed the deduction’s scheduled expiration after 2025, so it continues for 2026 and later years (IRC §199A(i) and amendment notes). The rate stays at up to 20%, and the law widened the phase-in range for the income-based limits and, starting in 2026, added a minimum deduction for taxpayers with at least $1,000 of qualified business income from businesses they materially participate in (IRC §199A(i)).

Sources

This guide is general information about how the rules work, last reviewed September 2026. It is not tax, legal or financial advice for your circumstances, and reading it doesn't create a client relationship. Tax rules, figures and thresholds change, and how they apply depends on your facts — talk to a tax professional before acting on anything here.

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