A few times a month, a small-business owner walks into our office with the same story: someone — a friend, an accountant, a podcast — told them they should be an S-Corp. Sometimes the recommendation is right. Sometimes it would cost them money. The difference is the math, and the math is rarely done before the recommendation is made.
This post is the framework I (William Pereira) walk through with new business clients in the structure-choice conversation. It is not advice for any specific situation. It is the lens that turns a casual recommendation into a defensible decision.
What an S-Corp election actually does, mechanically
Both LLCs and S-Corps are pass-through entities for federal income tax. Profits flow through to the owner's personal return either way. The income tax bill on a $200,000-profit business is roughly the same whether the entity is an LLC taxed as a sole proprietorship or an S-Corp.
What changes is how self-employment tax (Social Security and Medicare) gets applied.
How self-employment tax works in each structure
- LLC (default treatment, sole prop or partnership): 100% of net profit is subject to SE tax — 15.3% on the first $168,600 (2024 wage base, indexed) and 2.9% on the rest. Effective SE tax rate on a $200,000 profit business: roughly $24,000 — $26,000.
- S-Corp election: The owner is required to pay themselves "reasonable compensation" as a W-2 wage, which is subject to FICA (15.3% combined employer-employee). The remaining profit is distributed as a K-1 distribution, which is NOT subject to FICA or SE tax.
The savings come entirely from the difference between the reasonable-compensation salary (FICA-subject) and the total profit (no FICA on the K-1 portion). The bigger the gap between reasonable compensation and total profit, the bigger the savings.
What 'reasonable compensation' actually means
The S-Corp savings depend entirely on this number. The IRS requires S-Corp owner-employees to pay themselves a wage that reflects what someone would be paid to perform the same role at an arm's-length employer. The IRS has audited and litigated this point heavily, and the case law is clear: setting a low salary to maximize the K-1 distribution is one of the most common audit triggers in the small-business world.
The factors the IRS looks at:
- The owner's training, experience, duties, and responsibilities
- Time and effort devoted to the business
- Comparable salaries paid for similar services in similar industries
- Profit history and the relationship between profit and owner compensation
- The portion of the business profit attributable to the owner's personal services vs. capital invested
In practice, reasonable compensation for an active owner-operator in a service business is rarely below 40% — 60% of net profit. For some industries (medicine, law, consulting where the owner is the entire business), it is even higher. A $300,000-profit law firm where the owner is the only attorney is going to have a hard time arguing reasonable compensation below $200,000.
The break-even calculation
Once you have a defensible reasonable-compensation number, the math is direct. Take a service business with $200,000 net profit and reasonable compensation around $90,000 (defensible for a generalist owner-operator at this revenue level).
LLC default treatment
- Profit subject to SE tax: $200,000
- 12.4% Social Security portion on first $168,600 = $20,906
- 2.9% Medicare on full $200,000 = $5,800
- 0.9% Additional Medicare on amount over $200,000 (single) = $0
- Total SE tax: ~$26,706
- Half deductible against income tax → effective net SE cost ~$22,000
S-Corp election
- Reasonable comp (W-2 wage): $90,000
- FICA on $90,000: $13,770 (split as $6,885 employee + $6,885 employer, but owner pays both)
- K-1 distribution: $110,000 — NOT subject to FICA
- Add S-Corp compliance costs: ~$1,500 — $3,000/yr (separate return, payroll service, accounting time)
- Effective net cost: ~$15,000 — $17,000
Annual savings: roughly $5,000 — $7,000 net of compliance costs at this profit level. That savings scales with profit; at $400,000 profit and $130,000 reasonable comp, the savings can be $15,000+ per year.
When the S-Corp does not pay off
Several scenarios make the S-Corp election a worse choice than staying an LLC.
- Profit below $50,000 — 75,000. Compliance costs eat the savings.
- High reasonable compensation. If almost all the profit is the owner's services (high-end consulting, medical practices), there is little K-1 distribution left to save FICA on.
- Multiple-state operations. Several states tax S-Corp income differently than LLC income, sometimes worse.
- Plans to take in additional non-resident or non-individual investors. S-Corps have shareholder restrictions (max 100, only US individuals and certain trusts/estates). LLCs do not.
- Real estate held in the entity. S-Corps create tax problems on distributions of appreciated property that LLCs do not.
- Plans to sell the business. The buyer of an S-Corp's assets and the buyer of an LLC's assets have different tax positions, and structure choice can affect the price the buyer is willing to pay.
These are common-enough scenarios that the S-Corp election should not be defaulted into. It should be modeled.
Georgia state tax implications
Georgia generally conforms to the federal pass-through treatment of both LLCs and S-Corps, with one notable wrinkle: Georgia has a pass-through entity (PTE) elective tax that allows S-Corps and partnerships (including LLCs taxed as partnerships) to elect to pay state income tax at the entity level. This is a workaround for the federal SALT cap and can be valuable for owners who pay over the $10,000 SALT limit individually.
The PTE election is more or less attractive depending on profit level, the owner's individual tax situation, and the year. It is one more variable to model in the structure-choice conversation, and it does not reliably favor one structure over the other.
The compliance side that nobody mentions
An S-Corp election turns the business into a separate tax entity that has to file Form 1120-S each year. The owner has to be on payroll, with withholding, payroll tax deposits, W-2s, and quarterly 941 filings. The accounting has to be cleaner than the typical small-LLC accounting because the IRS scrutinizes S-Corp returns more closely.
S-Corp ongoing compliance
- Form 1120-S federal corporate return (separate from personal return)
- Form 1099-DIV or K-1 to shareholders
- Quarterly Form 941 payroll tax returns
- Annual Form 940 federal unemployment
- State payroll tax returns (Georgia DOL and Georgia DOR)
- Annual state corporate filing
- Workers comp coverage (depending on number of employees)
- Separate accounting for the W-2 wage and the K-1 distribution
For a sub-$100,000-profit business, this overhead can erase the savings. For a $250,000-plus profit business, it is a fraction of the benefit.
When the S-Corp election is genuinely the right answer
The S-Corp election is the right answer when:
- Net profit consistently exceeds reasonable compensation by more than $50,000 per year
- The owner has time and tolerance for the additional compliance
- The business is service-based with at least some profit attributable to capital, processes, or non-owner labor — not 100% the owner's personal services
- The state tax situation does not penalize S-Corp income relative to LLC income
- There is no near-term plan to take on non-qualifying investors or to sell the business
When all five conditions hold, the math works almost every time. When two or three hold, it is genuinely a model — not a default — and the model has to be redone every year as profit and circumstances change.
The conversation we have at the start
In a free initial consultation for a new business client, the structure conversation is part of the package. We do the actual model. We pull comparable salary data. We factor in the state tax wrinkle and the long-term growth plan. We tell you whether the S-Corp election is the right answer for your specific business — and we tell you when it is not.
There is no shortage of accountants and tax advisors who recommend the S-Corp election by default. There is a shortage of analysis that justifies it. We do the analysis.