The Core Tax Difference Between an LLC and an S-Corp
Every contractor who has cleared $100,000 in net profit has heard the advice: "You need to elect S-Corp status." The advice is usually correct, but the reasoning behind it is poorly understood, and the execution is where contractors get into trouble. Let us walk through the actual mechanics.
A single-member LLC is a disregarded entity for federal tax purposes. All of the business's net income flows through to your personal tax return on Schedule C. You pay income tax on the full amount, and you also pay self-employment tax on the full amount. Self-employment tax is 15.3% on net earnings up to the Social Security wage base ($168,600 in 2026) and 2.9% on net earnings above that threshold. The self-employment tax is the combined employee and employer share of Social Security and Medicare that W-2 employees split with their employer.
An S-Corp is not a separate type of entity. It is a tax election that an LLC (or a corporation) makes with the IRS by filing Form 2553. Once the election is in effect, the business must pay the owner a reasonable salary through payroll, withholding income taxes and employment taxes just like any other employee. The remaining net income after the salary passes through to the owner as a distribution, which is subject to income tax but not subject to self-employment or FICA taxes.
That distinction, salary versus distribution, is the entire source of the tax savings. Every dollar of profit that you can legitimately classify as a distribution instead of salary avoids the 15.3% (or 2.9%) self-employment tax.
A Side-by-Side Comparison: $3 Million Revenue, $250,000 Net Income
Let us work through a realistic example for a mid-size contractor. The company does $3 million in revenue, employs 15 field workers plus an office manager, and after all expenses (labor, materials, subs, insurance, equipment, overhead), the owner clears $250,000 in net profit.
Scenario 1: Standard LLC (No S-Corp Election)
The full $250,000 flows to the owner's Schedule C. Self-employment tax applies to 92.35% of net self-employment income (the IRS allows a deduction for the employer-equivalent portion), so the SE tax base is $230,875. On the first $168,600, the rate is 15.3%, producing $25,796 in tax. On the remaining $62,275, the rate is 2.9%, producing $1,806. Total self-employment tax: $27,602. The owner also gets to deduct half of the SE tax ($13,801) as an above-the-line deduction on their personal return.
Scenario 2: S-Corp Election with $130,000 Salary
The owner pays himself a W-2 salary of $130,000 through payroll. The company pays the employer's share of FICA on that salary: 6.2% Social Security ($8,060) plus 1.45% Medicare ($1,885), totaling $9,945. The employee's share ($9,945) is withheld from the paycheck. Total FICA on the salary: $19,890.
The remaining $120,000 ($250,000 net income minus $130,000 salary) is distributed to the owner. This distribution is subject to income tax but zero FICA. The S-Corp must file its own tax return (Form 1120-S) and issue a K-1 to the owner, and the owner reports the $120,000 on their personal return as S-Corp passthrough income.
The Savings
Under the LLC scenario, total self-employment tax is $27,602. Under the S-Corp scenario, total employment tax (employer plus employee FICA on the $130,000 salary) is $19,890. The difference is $7,712 in direct FICA savings. But wait. Under the LLC scenario, the owner deducts half the SE tax ($13,801), which at a 24% marginal rate saves $3,312 in income tax. Under the S-Corp scenario, the employer FICA ($9,945) is a deductible business expense, saving $2,387 at the same rate. The net income tax effect is $925 in favor of the LLC. After adjusting for this, the net annual savings from the S-Corp election is approximately $6,787.
However, many contractors set their salary lower. If we run the same scenario with a $100,000 salary (still defensible for certain contractor profiles), the FICA on salary drops to $15,300, and the distribution grows to $150,000. The net annual savings jumps to approximately $11,200. At a $130,000 salary, which is more conservative and IRS-defensible for a contractor generating $3 million in revenue, the savings are meaningful but not transformative.
Here is the counterintuitive part: the real savings become dramatic at higher net income levels. A contractor netting $400,000 with a $150,000 salary saves approximately $18,400 per year. A contractor netting $600,000 with a $175,000 salary saves roughly $22,000 per year. The savings scale with the gap between net income and reasonable salary.
What Is the Breakeven Point for Electing S-Corp?
The S-Corp election is not free. It introduces compliance costs that the standard LLC does not have. You must run payroll (even if you are the only employee on payroll), which means either an in-house payroll system or a payroll service ($50 to $200 per month). You must file a separate corporate tax return, Form 1120-S, which costs $1,500 to $3,000 in CPA fees depending on complexity. You need to maintain reasonable compensation documentation. And some states impose additional taxes or fees on S-Corps.
Adding up the compliance costs: payroll service at $1,200 per year, incremental CPA fees at $2,000 per year, and miscellaneous state filing fees at $800 per year puts the total at approximately $4,000 per year in additional overhead.
For the S-Corp election to make financial sense, the FICA savings must exceed this $4,000 annual cost. Working backward, the FICA savings on the gap between net income and reasonable salary is approximately 15.3% (for income below the Social Security wage base) on the distribution amount. To save $4,000, you need a distribution of roughly $26,000, which means net income of approximately $26,000 above your reasonable salary.
If your reasonable salary is $60,000 (for a small subcontractor generating $500,000 in revenue), the breakeven net income is about $86,000. If your reasonable salary is $80,000, the breakeven is about $106,000. As a practical rule of thumb, the S-Corp election starts making sense when your net income consistently exceeds $80,000 to $100,000, and the savings become substantial once net income exceeds $150,000.
Below that threshold, the compliance costs eat most or all of the tax savings, and the administrative burden is not worth the marginal benefit.
What Does the IRS Consider Reasonable Compensation?
The Factors the IRS Examines
The IRS does not define a specific dollar amount as "reasonable compensation." Instead, they use a facts-and-circumstances test that considers multiple factors. The most important ones for construction contractors are the nature and extent of services the owner provides (estimating, project management, client relationships, financial oversight), comparable compensation for similar roles in the construction industry, the company's revenue and profitability relative to the owner's salary, the time the owner devotes to the business, and the owner's qualifications and experience.
What Gets You Audited
The IRS has identified S-Corp reasonable compensation as a priority enforcement area. They are specifically looking for owners who pay themselves minimal salaries (or no salary at all) while taking large distributions. Here are the patterns that trigger scrutiny.
Zero salary with large distributions. This is the most obvious red flag. If your S-Corp distributed $200,000 to you and your W-2 shows zero, you will hear from the IRS. They will reclassify the distributions as wages, assess back employment taxes, and add penalties and interest.
Salary dramatically below industry norms. If you are the owner-operator of a $3 million contracting company and you pay yourself $45,000, the IRS will argue that no one with your responsibilities and qualifications would accept that salary in the open market. The construction industry is well-documented in Bureau of Labor Statistics data, and the IRS knows that a construction company president overseeing $3 million in revenue earns well above $100,000.
Salary that never increases despite growing revenue. If your company's revenue grew from $1 million to $5 million over five years but your salary stayed at $60,000, the static salary looks like a tax avoidance strategy rather than a reflection of market compensation.
Setting a Defensible Salary
For construction contractors, a defensible salary typically falls in these ranges based on company revenue. For companies doing $500,000 to $1 million in revenue, a reasonable owner salary is $60,000 to $90,000. For $1 million to $3 million in revenue, $90,000 to $140,000. For $3 million to $10 million, $130,000 to $200,000. For companies above $10 million, $175,000 to $300,000 or more.
These ranges assume the owner is actively involved in operations. If you are a passive investor and the company is run by a hired general manager, your reasonable salary could be lower. But most contractor-owners are deeply involved in estimating, project oversight, client relationships, and financial management, which justifies compensation at the higher end of the range.
Document your salary rationale annually. Pull comparable salary data from the Bureau of Labor Statistics (Occupational Employment and Wage Statistics), industry surveys from the Construction Financial Management Association (CFMA), or online compensation databases. A one-page memo in your corporate records explaining how you determined your salary is inexpensive insurance against an IRS challenge.
How Do State Taxes Affect the LLC Versus S-Corp Decision?
California's S-Corp Tax
California imposes a 1.5% tax on the net income of S-Corps, with a minimum tax of $800 per year. This means a California S-Corp with $250,000 in net income pays $3,750 in state entity-level tax that a standard LLC (which pays only the $800 minimum franchise tax) would not owe. The $2,950 additional state tax reduces the net federal FICA savings. For California contractors, the breakeven net income for the S-Corp election is higher than in states without an entity-level S-Corp tax, roughly $120,000 to $140,000 instead of $80,000 to $100,000.
New York City's Non-Recognition
New York City does not recognize S-Corp status. S-Corps operating in New York City are taxed at the C-Corp rate (8.85% on allocated income), which can eliminate most or all of the federal FICA savings for NYC-based contractors. If your construction company operates primarily within New York City, the S-Corp election may be a net negative after accounting for the city tax.
States with No Income Tax
In states with no personal income tax (Florida, Texas, Nevada, Wyoming, Tennessee, Washington, and others), the S-Corp decision is purely a federal analysis. There are no state-level complications, and the breakeven analysis is straightforward. These are often the states where the S-Corp election provides the highest net savings because there are no offsetting state taxes.
Pass-Through Entity Taxes
A growing number of states have enacted optional pass-through entity taxes (PTETs) that allow S-Corps and partnerships to pay state income tax at the entity level, generating a federal deduction that bypasses the $10,000 SALT cap. If your state offers a PTET (currently more than 30 states do), electing it through your S-Corp can provide additional federal tax savings of $2,000 to $10,000 or more per year, depending on your state tax rate and income level. This is a factor that tips the analysis further in favor of the S-Corp election for contractors in high-tax states.
What About the Qualified Business Income Deduction?
The Section 199A Qualified Business Income (QBI) deduction allows eligible pass-through business owners to deduct up to 20% of their qualified business income. Both LLCs and S-Corps are eligible for this deduction, but the calculation differs slightly.
For S-Corps, the QBI is the net income reported on the K-1, which excludes the owner's W-2 salary. For LLCs, the QBI is the full Schedule C net income minus half of the self-employment tax. At higher income levels (above $191,950 for single filers or $383,900 for joint filers in 2026), the deduction is limited by the W-2 wages paid by the business or the unadjusted basis of qualified property. S-Corps that pay a reasonable owner salary often have an advantage here because the W-2 wages increase the limitation threshold.
For most construction contractors, the QBI deduction does not dramatically change the LLC versus S-Corp comparison because both structures qualify. However, at income levels above the phase-in threshold, the S-Corp's W-2 salary can actually protect a larger QBI deduction. This is one of those areas where the tax planning gets nuanced enough that a blanket recommendation is irresponsible. Run the numbers with your CPA using your specific income level and filing status.
Common Mistakes Contractors Make with S-Corp Elections
Filing Form 2553 Late
The S-Corp election must be filed within 75 days of the start of the tax year (or within 75 days of forming the entity, if formed mid-year). Missing this deadline means the election does not take effect until the following year. The IRS does grant late election relief under Revenue Procedure 2013-30 if you meet certain conditions, but it requires additional paperwork and is not guaranteed. If you decide in October that you want S-Corp status for the current year, you may be too late.
Not Running Payroll from Day One
Once the S-Corp election is effective, you must run payroll for any owner who performs services. Some contractors file the election and then forget (or choose not) to set up payroll for months. This creates a compliance gap where the IRS can argue that distributions received during the no-payroll period should be reclassified as wages.
Mixing Personal and Business Expenses
S-Corps have stricter entity formality requirements than single-member LLCs. The IRS can challenge your S-Corp status if you commingle personal and business funds, fail to maintain corporate minutes, or treat the entity's bank account as your personal checking account. Maintain separate accounts, document shareholder distributions with formal resolutions, and keep your corporate records clean.
Ignoring the Payroll Tax Implications for Workers' Comp
Your workers' comp premium is based on payroll, and your owner salary is included in the payroll calculation. An owner who takes a $130,000 salary will pay workers' comp on that salary at the applicable class code rate. An LLC owner's guaranteed payment is not always included in the workers' comp payroll basis, depending on the state. This workers' comp cost difference, often $5,000 to $15,000 per year, should be factored into the LLC versus S-Corp analysis but rarely is.
Making the Decision
The LLC versus S-Corp decision is not permanent. You can elect S-Corp status when your net income justifies it and revoke the election if circumstances change (though revocation restricts you from re-electing for five years). The best approach is to monitor your net income trajectory and make the election when you have two consecutive years of net income above $100,000 with a reasonable expectation that the trend will continue.
If you are a contractor netting less than $80,000, stay with the LLC. If you are netting $80,000 to $150,000, run the numbers with a CPA who understands construction before deciding. If you are netting above $150,000, you are almost certainly leaving money on the table without the S-Corp election.
The most important thing is to get the reasonable compensation right. The tax savings from the S-Corp election are real, but they are not worth an IRS audit and reclassification. Set a defensible salary, document your rationale, and let the distribution savings accumulate year after year. Over a decade of contracting, the cumulative FICA savings from a properly structured S-Corp can easily exceed $150,000 to $200,000, and that money compounds if you reinvest it in your business or retirement accounts.