S-Corp vs. LLC: Taxes & How Owners Get Paid

"How do I pay myself?" is one of the most common questions new owners ask, and the honest answer is that it depends entirely on your business structure. Get it wrong and you are not just making a bookkeeping mistake: you can trigger real IRS penalties, back taxes, and in bad cases an audit. Here is how it actually works, structure by structure.

If you run a sole proprietorship, or a single-member LLC that has not made the S-Corp election, you pay yourself through an owner's draw. You simply transfer money from the business bank account to your personal account whenever you want, in whatever amount you want. There is no payroll, no withholding, and no paperwork beyond your own bookkeeping. Elena, who runs a one-person bakery as a single-member LLC, might draw $2,000 in a slow month and $6,000 in a busy one. It does not matter to the IRS how much she actually drew: at tax time she owes tax on the bakery's full net profit for the year, whether she withdrew all of it, some of it, or left it sitting in the business account to buy a new oven.

If you run a partnership or a multi-member LLC, the same draw mechanic applies, just split among the partners according to whatever percentages your operating agreement specifies. These are usually called partner draws or distributions rather than owner's draws, but the underlying rule is identical: no payroll, no withholding, tax owed on your share of profit regardless of what you actually withdrew.

An S-Corp election changes this. It is a tax election, not a separate legal entity: an LLC or a corporation elects to be taxed as an S-Corp, and it does not stop being an LLC or a corporation in the process. Once you elect it, you are required to pay yourself a W-2 salary through actual payroll, with normal tax withholding, exactly like any other employee on the company's books. Any remaining profit beyond that salary can then be paid out as a distribution, which is not run through payroll and is not subject to payroll tax. That salary and distribution split is exactly what creates the tax savings covered later in this lesson, and exactly why the IRS pays close attention to how owners set the salary number.

A C-Corp uses the same W-2 salary structure as an S-Corp for its owner-employees, but the profit left over after salary is not a pass-through distribution. It stays inside the corporation, taxed at the corporate level, and if any of it is later paid out to shareholders as a dividend, it is taxed again on their personal returns. That double layer is covered in its own section below.

By default, the IRS does not treat an LLC as its own tax category. It looks through the LLC to the owner or owners behind it. A single-member LLC is taxed exactly like a sole proprietorship; a multi-member LLC is taxed like a partnership. Either way, all of the business's net profit (not just what you drew out) is subject to self-employment tax, currently 15.3%, covering Social Security and Medicare, on top of your regular federal and state income tax.

Here is why the rate is 15.3%, and why it applies to profit rather than to what you spent. A regular employee's paycheck funds Social Security and Medicare through a 7.65% tax withheld from wages, matched by another 7.65% their employer pays on top, for 15.3% total, split two ways between employee and employer. When you are self-employed, there is no separate employer to cover the other half: you are both, so the full 15.3% lands on you. And the tax is calculated on profit the business earned, not on what you personally spent, the same way an employee owes income tax on the wages they earned, not on however much of that paycheck they happened to spend that month.

This is the part that catches a lot of first-year LLC owners off guard. Marcus runs a home-repair LLC that nets $80,000 in its first full year. He reinvests most of it into a used van and a season's worth of materials, drawing out only about $20,000 for himself to live on. Marcus still owes self-employment tax and income tax on the full $80,000, not the $20,000 he actually took home, because the tax follows what the business earned, not what he personally spent. A profitable LLC can generate a real tax bill even in a year where the owner reinvested almost everything and lived on very little.

Electing S-Corp taxation does not change your liability protection or your day-to-day operations. It only changes how the IRS taxes your profit. The mechanism is straightforward: you split net profit into a W-2 salary, which is subject to payroll tax, and a distribution, which is not. Because payroll tax only applies to the salary portion, splitting profit this way can meaningfully lower your total tax bill, but only once you are profitable enough that the cost of running payroll (typically a few hundred dollars a year for a payroll service, plus your accountant's time preparing the S-Corp return) is worth it. Most advisors put that breakeven point somewhere around $40,000 to $60,000 in net profit, though it depends on your specific numbers. Run the calculator below with your own figures before deciding.

Here is a worked comparison. Priya runs a marketing consultancy as a single-member LLC and nets $120,000 in profit. Taxed the default way, she owes 15.3% self-employment tax on the full $120,000, about $18,360. If she elects S-Corp status and pays herself a reasonable salary of $70,000 (defensible for a consultant with her experience and client base), payroll tax applies only to that $70,000, about $10,700, with the remaining $50,000 paid out as a distribution free of payroll tax. That is a real savings of roughly $7,600 a year, before accounting for payroll service fees and the added cost of preparing a corporate return. The savings scale with the gap between her actual profit and her reasonable salary, which is exactly why the IRS cares how that salary number gets set.

The reasonable-salary rule exists because Social Security and Medicare are funded by payroll tax on wages: that is the entire mechanism. If an S-Corp owner could pay themselves $0 salary and take everything as a distribution, they would get all the benefit of running the business while contributing nothing to the system that funds their own future Social Security and Medicare benefits, and every other S-Corp owner would have the same incentive to do the same thing. Reasonable salary is the rule that closes that gap: you can still get the legitimate tax benefit of the salary and distribution split, but you cannot use the split to opt out of the payroll tax system entirely. It is an anti-abuse rule protecting the funding mechanism, not an arbitrary hoop.

The same logic extends to ownership, which is why an S-Corp is allowed only one class of stock. If an S-Corp could issue different classes of stock (one with a bigger claim on profit, one with voting rights but no economic stake, and so on), owners could effectively route profit however they wanted regardless of actual ownership percentage, which defeats the simple, strictly proportional pass-through system Congress built Subchapter S around in the first place. One class of stock keeps "your percentage of ownership equals your percentage of profit and loss" true without exception, which is also exactly why most venture capital deals, which use preferred stock with special rights, are structurally incompatible with S-Corp status.

The tax savings are only half the picture. An S-Corp election also comes with real eligibility restrictions that can disqualify you or trip you up later: a 100-shareholder cap, ownership limited to U.S. individuals and certain trusts and estates (no companies, partnerships, or non-U.S. investors), and time limits on trust ownership after the original owner's death. See "Why You Might NOT Choose Each Structure" in the Choosing Your Business Structure module for the full list before you file the election.

A C-Corp is the one structure covered in this lesson that is not pass-through. The company itself pays corporate income tax on its profit, and then if any of that profit is distributed to owners as dividends, the owners pay tax on it again on their personal return. This is what people mean by double taxation, and it is the main tax tradeoff founders accept in exchange for the structure institutional investors require.

Here is why this happens, structurally. A C-Corp is a genuinely separate legal person under the law, not a pass-through label: an actual distinct taxpayer with its own income. The ordinary rule in the tax code is that income is taxed to whoever receives it. The corporation receives income and is taxed on it. When it then pays some of that already-taxed income out to a shareholder as a dividend, the shareholder has also received income, under that same ordinary rule. An LLC or S-Corp avoids this through a specific pass-through election that tells the IRS not to tax the entity itself, only the owner. A C-Corp simply does not have that election. Double taxation is not a penalty for choosing C-Corp: it is what happens by default any time two separate legal persons both receive income from the same dollar, which is exactly the tradeoff you accept in exchange for the corporate structure institutional investors require.

Sam co-founded a software company as a C-Corp specifically because the venture firm investing in the seed round required preferred stock, something only a C-Corp can issue. Sam knows that if the company is ever profitable enough to pay dividends, that profit will be taxed twice: once at the corporate level, once again on Sam's personal return. In practice, most venture-backed C-Corps reinvest everything back into growth for years and never pay a dividend at all, so the double-taxation cost that matters most in practice usually shows up later, at an exit such as a sale or an IPO, not through dividends along the way.

There is one major exception worth knowing about if you are a C-Corp founder or early employee: Qualified Small Business Stock, under Section 1202 of the tax code, can let you exclude a large portion, potentially all, of your capital gain when you eventually sell qualifying stock, if you meet specific requirements around how long you have held it and how the company is structured. The rules here are detailed, they were significantly changed by recent tax legislation, and eligibility depends on facts specific to your company, including industry, asset size, and when the stock was issued. This is genuinely one of the highest-value provisions in the tax code for startup founders and early employees, and also one of the easiest to accidentally disqualify yourself from without knowing it. Talk to a startup-experienced CPA or attorney about QSBS eligibility before you need it, not after: some of the requirements depend on decisions made at the time stock is issued, which is too late to fix retroactively.