S-Corp vs LLC for contractors: when each one makes sense

Almost every contractor I talk to has heard the same advice: form an S-Corp and save thousands on taxes. The advice isn’t wrong — it’s just incomplete. The S-Corp election is a powerful tax tool when used at the right time, on the right level of income. Used too early, it costs more than it saves. Used incorrectly, it creates audit exposure that can wipe out years of savings.

LLC and S-Corp are not alternatives

This is the biggest misconception. People say “should I be an LLC or an S-Corp?” as if they’re picking from a menu. They aren’t.

An LLC is a legal entity. Formed at the state level. Gives you liability protection. The LLC is the legal wrapper around your business.

An S-Corporation is a federal tax election. Not an entity. A way of being taxed. You file IRS Form 2553 to elect S-Corp tax treatment. The election sits on top of an underlying entity — either an LLC or a C-Corp.

For 95% of contractors, the question isn’t “LLC or S-Corp” — it’s “should my LLC elect S-Corp tax treatment?”

How the S-Corp election saves money

When you operate as a sole proprietor or default-treated LLC, every dollar of business profit is subject to self-employment tax — 15.3% on the first $168,600 and 2.9% above. SE tax is on top of regular income tax. It’s the part that hits self-employed people hardest.

When you elect S-Corp treatment, your business profit splits into two parts:

1. A “reasonable salary” you pay yourself as a W-2 employee, subject to payroll taxes.
2. The remainder, taken as distributions. Distributions are not subject to self-employment tax.

If your business profits $200,000 and you pay yourself $100,000 as a reasonable salary, the $100,000 in distributions escapes the 15.3% SE tax — $15,300 in tax savings. Real money. But those savings get eaten back by payroll service ($40–80/mo), additional tax return ($700–1,500), bookkeeping discipline ($200–500/mo), state-level fees.

The break-even math by income level

The pattern: below $80k, the math doesn’t justify the complexity. Between $80k and $120k, you start picking up real savings. Past $150k, the S-Corp becomes a serious tax-planning tool.

The reasonable salary problem

The S-Corp savings depend on splitting profit between salary and distributions. The IRS noticed S-Corp owners had an incentive to set their salary at $1 and take everything else as distributions. The standard the IRS uses is reasonable compensation: what would you pay an arm’s-length employee to do the work you do for your S-Corp?

Some general benchmarks:

• 40–60% of net profit as salary, the remainder as distributions
• For active service providers (contractors), the IRS pushes for the higher end
• Comparable wage data from sources like Bureau of Labor Statistics is the strongest defense
• If your salary is below the BLS median for your occupation, you have a problem

I generally recommend contractors target 50% of net profit as salary, with documentation showing how that number was reached.

When the S-Corp doesn’t make sense

Below ~$50k net profit: Costs exceed savings. Stay default-treated.

If your business is really just you with a few side jobs: The administrative weight is unjustified.

If you’re inconsistent year-to-year: The election is technically revocable but practically sticky.

If your state has hostile S-Corp rules: Some states tax S-Corp profit at the entity level. Check before electing.

How to elect S-Corp status

Form 2553 is the election form. To take effect for the current calendar year, it must be filed within 2 months and 15 days of the start of the tax year — by March 15 for a calendar-year business.

Once elected: set up payroll (Gusto, ADP, Paychex, or QuickBooks Payroll), determine your reasonable salary, run payroll on a regular schedule, withhold federal income tax, file quarterly Form 941, and at year-end file Form 1120-S and issue yourself a W-2 plus a Schedule K-1.

The decision in one sentence

If you take only one thing from this article, take this: Net profit consistently over $80k? Run the math. Over $150k? Strongly consider electing. Over $250k? You’re probably leaving money on the table by not electing.