LLC or S-corp? Business structure for contractors

This is one of the most common questions contractors ask, and one of the most commonly answered badly — usually by someone at a barbecue who saved money once and now recommends it to everybody.

The structure genuinely matters. So does understanding what it commits you to.

They are two different kinds of thing

This trips people up constantly, so it is worth being precise.

An LLC is a legal structure. You form it with your state. It separates the business as a legal entity from you personally, which is where liability protection comes from.

An S-corp is a tax election. It is not a separate kind of company. An LLC can elect to be taxed as an S-corp and remain an LLC in every other respect.

So "LLC or S-corp" is not really the choice. The choice is what tax treatment your entity elects.

Default treatment

A single-member LLC with no election is a disregarded entity for tax purposes. Business profit flows to your personal return, and self-employment tax applies to that profit — whether or not you took the money out.

That last part surprises people. Leave $60,000 in the business to fund next year and you are still taxed on it.

What the S-corp election changes

Elect S-corp treatment and the business must pay you a reasonable salary through actual payroll, with withholding, filings and a W-2 at year end. Profit above that salary can be taken as a distribution that is not subject to self-employment tax.

That gap is where the saving comes from. It is real, and for a contractor with meaningful profit above a reasonable salary, it can be substantial.

What it costs you

The saving is not free, and the costs are the part people skip.

You now run payroll for yourself. Every period, on time, with the filings that go with it. That is a real administrative obligation and a real cost.

A separate business return is required. More work, and your CPA will charge for it.

Reasonable compensation becomes your problem. This is where contractors get into trouble. The saving increases the less you take as salary, so the temptation is a token wage and a large distribution. That pattern is exactly what examinations look for. Recharacterised, you owe the payroll taxes plus penalties and interest.

Your books have to be right. Distributions and wages must be genuinely separate. Draws must sit in equity. If your books cannot demonstrate the distinction, the election is hard to defend.

Roughly when it starts to make sense

There is no threshold in the law, and anyone quoting one confidently is guessing at your circumstances. But the shape of it is:

If your profit is not much above what you would have to pay someone to do your job, there is little room between salary and distribution, and the extra cost and admin eats the saving.

Once profit sits meaningfully above a defensible salary, the arithmetic starts to favour the election — and the further above, the clearer it gets.

Working out where you sit requires knowing your actual profit, which requires books that are right. Which is usually the real blocker, not the decision itself.

The reasonable salary question

The defensible answer is what you would have to pay someone else to do what you do. For a working owner running a small crew that is typically a lead tech's wage plus something for estimating and management.

Document how you arrived at it. A figure with reasoning behind it is a completely different conversation from a figure that appeared.

There is more on this in how much should I pay myself.

What to do

Get your books accurate first. Every input to this decision — real profit, a defensible salary, whether the saving beats the cost — comes out of them, and a decision made on wrong numbers is worse than no decision.

Then have the conversation with a CPA who has seen your actual figures, not a general rule.

Related

• How much should I pay myself?
• Separating business and personal money
• What contractors can actually deduct

General information about how these structures work, not tax or legal advice. Entity choice, elections and reasonable compensation depend entirely on your circumstances and your state — decide them with your CPA.