Here’s something that keeps me up at night as a CPA: I meet business owners every single day who are unknowingly throwing away tens of thousands of dollars in taxes. And the frustrating part? Most of them have no idea it’s even happening.
If you’re operating as a sole proprietorship or running a single-member LLC without making any tax elections, there’s a really good chance you’re overpaying somewhere between $15,000 and $30,000 every year. That’s not a typo. And honestly, your accountant might not have flagged this for you yet.
I’m Tiffany Phillips, and I’ve spent years helping business owners navigate the murky waters of tax strategy. Today, I want to walk you through one of the most powerful tax-saving decisions you’ll ever make: choosing the right business structure.
The Biggest Misconception About LLCs
Let me start by clearing up something I hear almost every single day. Someone sits down with me and says, “I’m taxed as an LLC.” And I have to gently stop them right there.
Here’s what most people don’t realize: LLC is a legal structure, not a tax structure. There’s actually no such thing as being “taxed as an LLC” in the eyes of the IRS.
When you form an LLC, you’re creating legal protection for your personal assets. That’s great and important. But from a tax perspective, your LLC is like a blank canvas. You still need to choose how you want to be taxed. Your options include:
- Sole proprietorship (single-member LLC default)
- Partnership (multi-member LLC default)
- S corporation (requires election)
- C corporation (requires election)
This flexibility is actually the beauty of LLCs. You get legal protection combined with tax choice. But here’s the problem most business owners run into.
The Default Trap: If you set up a single-member LLC and don’t make any tax elections, you’re automatically treated as a sole proprietorship for tax purposes. This default choice is often the absolute worst option from a tax perspective.
Why Sole Proprietorship Taxation Hurts So Much
When you’re taxed as a sole proprietorship, every single dollar of profit gets hit with self-employment tax. That’s 15.3% right off the top, before we even talk about your regular income tax.
Think about it this way: if you’re an employee somewhere, you pay 7.65% for Social Security and Medicare, and your employer pays the other 7.65%. When you’re self-employed, you’re both the employee and the employer, so you pay both sides. The full 15.3%.
Let me show you what this actually looks like with real numbers, because seeing it laid out makes the impact so much clearer.
The $100,000 Profit Scenario
Let’s say your business brings in $125,000 in revenue. After $25,000 in expenses, you’re left with $100,000 in profit. Here’s what happens under different structures.
Sole Proprietorship:
- Self-employment tax: $15,300
- Federal income tax (24% bracket): ~$18,000
- State taxes: ~$5,000
- Total taxes: $38,300
- You keep: $61,700
S Corporation:
- Reasonable salary: $40,000
- Social Security/Medicare on salary: $6,120
- Distribution (no self-employment tax): $60,000
- Income tax on full amount: similar
- Total taxes: ~$29,000
- You keep: $71,000
That’s nearly $10,000 more in your pocket every single year from making one strategic election. Over ten years, we’re talking about $100,000 in additional wealth. That’s college tuition. That’s a down payment on a house. That’s real money that could be working for you instead of going to taxes.
When Does the S Corporation Election Make Sense?
I get this question constantly, and the answer isn’t one-size-fits-all. But here’s what I generally tell people.
The sweet spot for S corporation election is typically when you’re making around $60,000 or more in annual profit. Below that threshold, the additional complexity and costs (payroll processing, extra accounting fees) might not justify the savings.
But once you cross that line, the self-employment tax savings usually make it a no-brainer. Especially if you’re in a service-based business where profits are high relative to expenses.
A Real Client Example
I had a marketing consultant come to me who was making $150,000 annually. She was structured as a sole proprietor and paying $22,000 every year just in self-employment taxes. That’s before income taxes even came into play.
We elected S corporation status. She took a reasonable salary of $60,000 and the remaining $90,000 came out as distributions. Her self-employment taxes dropped to $9,200. The annual savings? $12,800 per year.
The setup cost her about $2,000 initially, plus roughly $3,000 annually in additional accounting and payroll costs. Even after those expenses, she’s netting over $120,000 in savings over the first decade. It’s one of those decisions that literally pays for itself in the first few months.
What About C Corporations?
C corporations get a bad rap, but they can be incredibly powerful in the right situations. The corporate tax rate is a flat 21%, which can be lower than your personal rate if you’re in a high bracket.
C corps make the most sense when you’re planning to retain significant profits in the business for growth, or when you’re building toward a future sale. There’s also this amazing tax benefit called Section 1202, which can exclude up to $10 million in capital gains when you sell qualified small business stock that you’ve held for five years.
I worked with a software company that structured as a C corp specifically because they were reinvesting everything back into the business. Instead of paying 37% on those retained earnings at their personal rate, they paid 21% at the corporate level. Over five years, that saved them over $200,000.
The Five Biggest Mistakes to Avoid
I’ve seen these mistakes cost people hundreds of thousands of dollars over time. Please learn from other people’s expensive lessons.
1. Putting Rental Real Estate in an S Corp
Rental income isn’t subject to self-employment tax anyway, so there’s literally no benefit to using an S corp structure. Plus, getting real estate out of an S corp later can create a huge taxable event. Just don’t do it.
22. Taking Unreasonably Low Salaries
The IRS is getting really aggressive about this. If you’re taking $20,000 in salary and $200,000 in distributions, you’re going to have problems. A general rule of thumb is 40-50% of your distributions should be reasonable salary. Document your decision-making process.
3. Ignoring State Tax Rules
Some states don’t recognize S corp elections or have additional taxes that eat away at your federal savings. California, I’m looking at you with that $800 minimum franchise tax.
4. Copying Someone Else’s Structure
What works for your friend’s e-commerce business might be completely wrong for your consulting practice. Your situation is unique and should be treated that way.
5. Never Reviewing Your Structure as You Grow
What made sense when you were making $50,000 might be completely wrong at $500,000. I recommend reviewing your structure annually with your tax advisor.
Costly Mistake Example: I had a client put three rental properties into an S corp thinking they’d save on taxes. Not only did they get zero benefit, but when they needed to refinance, removing the properties created a $200,000 taxable distribution. It was completely avoidable if they’d structured correctly from the start.
Advanced Strategy: Layering Multiple Entities
Once you’re making seven figures, things get more sophisticated. I have clients who use multiple entity types strategically:
- S corp for active business income
- C corp for intellectual property and licensing
- LLC for real estate holdings
Each income stream gets optimized separately. It’s more complex, sure, but when you’re dealing with millions of dollars, the savings justify the additional structure.
What You Need to Do Next
If you’re currently operating as a sole proprietorship or single-member LLC without any elections, and you’re making meaningful profit, you need to have a conversation with a tax professional who understands entity selection. Not all CPAs specialize in this area.
The beautiful thing about the S corporation election is that you can make it at any time (though it’s best to do it at the beginning of a tax year for simplicity). You’re not locked into your current structure forever.
Start by looking at your last two years of tax returns. What was your net profit? If you’re consistently above $60,000, an S corp election probably makes sense. If you’re above $150,000, it’s almost certainly costing you money to stay as a sole prop.
Want to Dive Deeper? If you’re serious about keeping more of what you earn, grab my book “Your Biggest Expense” at yourbiggestexpense.com. I cover entity selection plus dozens of other strategies that can save you thousands every year.
The Bottom Line
Your business entity choice is one of the most important tax decisions you’ll ever make. It’s not set-it-and-forget-it either. As your business grows and evolves, your structure should too.
The same business profit can result in tax bills that differ by $10,000 to $30,000 annually, depending entirely on how you’re structured. That’s money that could be in your pocket, building your wealth, funding your retirement, or reinvesting in your business.
Remember these key principles:
- LLC is a legal structure, not a tax classification
- Self-employment tax offers the biggest opportunity for savings
- There’s no universal right answer—your situation is unique
- Review your structure regularly as your business grows
It’s not what you make, it’s what you keep. And choosing the right business structure is one of the most powerful ways to keep more of your hard-earned money.
Frequently Asked Questions
Q: What’s the difference between an LLC and an S corp?
An LLC is a legal entity that protects your personal assets from business liabilities. An S corp is a tax classification. You can actually be both—an LLC that elects to be taxed as an S corporation. The LLC provides legal protection while the S corp election provides tax savings by reducing self-employment taxes on a portion of your income.
Q: How much should I pay myself as an S corp owner?
You must pay yourself a “reasonable salary” based on what someone with your skills and responsibilities would earn in your industry. A general guideline is 40-50% of your total compensation, though this varies by industry and role. The IRS scrutinizes unreasonably low salaries, so document your decision-making process and industry research.
Q: Can I switch from sole proprietorship to S corp mid-year?
Technically yes, but it’s complicated. S corp elections are typically most effective when made by March 15th to apply to the current tax year. If you miss that deadline, you may need to wait until the following year. However, there are some workarounds involving late election relief. Talk to a tax professional about your specific timing.
Q: Will an S corp election work for my real estate rental income?
No, and this is a common expensive mistake. Rental income isn’t subject to self-employment tax anyway, so there’s no benefit to S corp treatment. In fact, it can create problems down the road if you need to refinance or sell. Keep rental properties in a standard LLC or hold them personally.
Q: What are the downsides of S corporation status?
S corps require more administrative work including payroll processing, quarterly payroll tax filings, and generally higher accounting costs (typically $2,000-$5,000 annually more than sole proprietorship). You’ll also need to maintain separate business bank accounts and run payroll for yourself. The tax savings usually far outweigh these costs once you’re making over $60,000 in profit.
Q: When should I consider a C corporation instead of an S corp?
C corps make sense when you’re retaining significant profits in the business for growth (rather than taking them as personal income), planning for a future sale and want to take advantage of Section 1202 capital gains exclusion, or need more flexibility in ownership structure than S corps allow. The flat 21% corporate tax rate can also be advantageous for high-income earners who are reinvesting profits.
