LLC vs. S-Corp vs. Sole Prop — which one and when

The short version

| Situation | Usually the right fit | | --------- | --------------------- | | Side income, very low profit, no employees | Sole proprietor | | Real customers, contracts, any physical risk | LLC | | Consistently solid profit, willing to run payroll | LLC with S-corp election | | Two or more owners | LLC (with an operating agreement) | | Raising outside investment | C-corp |

There is no magic profit number where an S-corp election becomes correct. The honest test is whether the tax savings on your distributions exceed the real annual cost of payroll processing, a separate business tax return, and extra bookkeeping. Run that math with a CPA on your actual numbers before you elect.

What each one actually gives you

• Sole proprietor: no formation paperwork, but unlimited personal liability. Your personal assets are exposed to business claims.
• LLC: pass-through taxation with a liability shield, plus an annual report filing in your state. This is the default answer for most PNW service businesses.
• S-corp election: an LLC (or corporation) can elect S-corp status, which lets you split income into a reasonable salary plus distributions. Only the salary portion is subject to Social Security and Medicare tax. That's the savings.
• C-corp: separate taxable entity. Right for venture-backed companies, rarely right for a local service business.

"Reasonable salary" is not a percentage

The IRS does not publish a formula. It evaluates what you pay yourself against the services you actually perform — your duties, time, experience, and what comparable businesses pay for similar work. Owners who pay themselves an artificially low salary to shrink payroll tax are the ones who get reclassified on audit. Document how you arrived at your number.

The deadline that catches people

File IRS Form 2553 no later than two months and 15 days after the beginning of the tax year the election is to take effect — for a calendar-year business, that's March 15. Miss it and the election generally applies to the following year.

If you missed it, don't assume you're out of luck: the IRS provides late election relief under Rev. Proc. 2013-30 when you have reasonable cause and act promptly.

Common mistakes

• Electing S-corp status on modest profit and losing the savings to accounting fees
• Signing client contracts personally instead of through the entity
• Mixing personal and business money — commingling is the classic way to "pierce the veil" and lose the liability protection you paid for