Which Is Best, LLC or S Corp?

The question feels like it has an answer. It does not, at least not in the form most people ask it, because an LLC and an S corp are not two options on the same menu. One is a legal entity created under state law. The other is a tax classification granted by the federal government. You can have both at the same time, and for a profitable California business that is frequently the right answer.

Once you understand that you are not choosing between two competing structures, the real decision comes into focus. The LLC question is about liability and governance. The S corp question is about how the IRS taxes the money your business earns. Conflating them is the single most common mistake we see at intake, and it usually costs the business owner money in one of two directions: overpaying self-employment tax for years, or electing S corp status before the numbers justify the added compliance.

An LLC Is a Legal Entity. An S Corp Is a Tax Election.

A limited liability company is formed when you file articles of organization with the California Secretary of State and pay the fee. From that moment, you have a legal entity that exists separately from you, with its own liability shield. If the business is sued, the LLC's structure is what stands between the claim and your personal assets, provided you have respected the formalities that keep that shield intact.

What the LLC does not do is tell the IRS how to tax you. By default, a single-member LLC is a disregarded entity, which means all of its profit lands on your personal Schedule C and is subject to self-employment tax under IRC § 1401 at a combined 15.3 percent rate, funding Social Security and Medicare. A multi-member LLC defaults to partnership taxation. Neither default involves the word "corporation," and neither default gives you any mechanism to reduce that self-employment tax exposure.

An S corp is not an entity you form. It is an election you make by filing IRS Form 2553, asking the federal government to tax your existing entity under Subchapter S of the Internal Revenue Code. Your LLC remains an LLC under California law. Its liability shield does not change. What changes is the tax treatment, and specifically the ability to split your income between a reasonable salary and distributions that are not subject to self-employment tax. That is the entire point of the election, and it is why "LLC or S corp" is the wrong frame. The accurate frame is "LLC taxed as a disregarded entity, or LLC taxed as an S corp."

The Real Question Is How Your Profit Should Be Taxed

Because the liability question and the tax question are separate, the decision you are actually making is about money flow. Under default LLC taxation, every dollar of net profit is exposed to self-employment tax. Under S corp taxation, you pay yourself a reasonable W-2 salary, that salary carries payroll tax, and the remaining profit comes to you as distributions that avoid the 15.3 percent layer. The savings are real, but they only exist above the profit threshold where the spread between salary and distributions outweighs the cost of running an S corp.

That threshold matters in California more than in most states, because electing S corp status here triggers the California franchise tax on S corporations under California Revenue and Taxation Code section 23802, which is 1.5 percent of the entity's net income with an annual minimum of 800 dollars. A single-member LLC taxed as a disregarded entity does not pay that 1.5 percent. So the S corp election in California carries a state tax cost that the federal savings have to overcome before the election makes sense.

As a rough orientation, most practitioners place the inflection point somewhere between 40,000 and 60,000 dollars of net profit. Below that, the payroll administration, the separate Form 1120-S return, the higher accounting fees, and the California 1.5 percent tax often eat the savings. Above it, the math moves in your favor and keeps moving as profit grows, because the compliance costs are largely fixed while the self-employment tax savings scale with the size of your distributions.

When the LLC Alone Is the Better Answer

For a business that is early, low-margin, or generating modest profit, the LLC taxed under its default rules is frequently the smarter structure. You keep the liability protection, you avoid the payroll infrastructure, and you do not pay California's 1.5 percent franchise tax on net income. Simplicity has a value that does not appear on a tax return but shows up every quarter when you are not filing payroll deposits or paying a payroll service.

There is also an eligibility dimension that can settle the question before the math does. The S corp election is only available to entities that meet the small business corporation requirements of IRC § 1361. You cannot have more than 100 shareholders, every owner must be a U.S. citizen or resident, you cannot have a corporation or partnership as a member, and you are limited to one class of ownership interest. If you have a foreign co-founder, a venture fund on your cap table, or plans to raise priced equity, the S corp election may be unavailable or actively counterproductive, and the LLC taxed as a partnership is the better home for that complexity.

The timing rules under IRC § 1362(b) add another wrinkle. The election generally must be filed within two months and fifteen days of the start of the tax year you want it to cover. Miss that window and you are either waiting until next year or seeking late election relief under Rev. Proc. 2013-30, which requires showing reasonable cause and is not guaranteed. None of this means the S corp is wrong. It means the decision has moving parts that a generic answer cannot account for.

When Electing S Corp Status Is the Better Answer

Once your LLC is consistently netting six figures and your ownership structure is clean, the S corp election usually pays for itself several times over. Consider an LLC netting 200,000 dollars in California. Under default taxation, the full amount is exposed to self-employment tax. Elect S corp status, pay a defensible salary of 90,000 dollars, and you carry payroll tax on the salary while taking roughly 110,000 dollars as distributions outside the 15.3 percent layer. Even after the California 1.5 percent franchise tax and the cost of payroll, the net annual savings are meaningful and they recur every year you maintain the structure.

The constraint that makes or breaks this is reasonable compensation. The IRS knows the salary-plus-distribution structure and polices it. Under the body of authority interpreting IRC § 3121 and reflected in cases like David E. Watson, P.C. v. United States, an S corp owner who pays an unreasonably low salary to inflate distributions invites reclassification of those distributions as wages, plus back payroll taxes and penalties. The election is not a loophole. It is a legitimate structure that requires you to pay yourself like the market would pay someone doing your job, and then take what remains as a return on the business.

There is also a layer most owners miss: the qualified business income deduction under IRC § 199A interacts with the salary decision. For a non-service business, the W-2 wages your S corp pays (including your own salary) can support a larger 199A deduction once your taxable income climbs past the threshold where the deduction starts to be limited by wages. For a specified service business, the deduction phases out entirely at higher income regardless of how you are structured. The detail itself is not the point. The point is that the LLC-versus-S-corp choice ripples into other parts of your return, and the right answer in one year can shift in the next as your income and the rules move. This is a decision to revisit annually, not one to make once and forget.

So which is best, LLC or S corp? For most profitable California businesses, the honest answer is an LLC that has elected to be taxed as an S corp, made at the point where the profit justifies the cost. The liability protection comes from the LLC. The tax efficiency comes from the election. Treating them as rivals is how owners end up with the wrong answer to a question they did not realize they were asking.

Related reading: disadvantages of S corporation, do you pay more taxes as an LLC or S corp, is it better to be a sole proprietor or S corp, why choose an S corporation rather than a sole proprietorship. For the full practice overview, see our S-Corp Attorney page.

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The LLC-versus-S-corp question is really a sequencing question, and getting the sequence right is what an intake session is built to do. Delina works with founders and creators whose businesses have grown past the point where the default tax treatment still serves them.

If you're ready to make a deliberate decision about your entity and its tax election instead of guessing, book a paid intake with Delina. This is not a free call. It is a focused, strategic session with an attorney who has read everything above and has specific opinions about your situation.