LLC or S Corporation? How the Choice Changes Your Taxes in Texas

One of the most common questions in David Tucker's practice is some version of "should I be an LLC or an S corp?" The question mixes two different things, which is why the answer never seems clear. This article separates them.

An LLC is a legal entity. An S corporation is a tax election.

A limited liability company is formed with the Texas Secretary of State. It gives you a legal entity separate from yourself, which is where the liability protection comes from. By itself, forming an LLC does not change how you are taxed.

By default, the IRS ignores a single-member LLC for income tax purposes: you report the business on Schedule C of your personal return, exactly as a sole proprietor would. A multi-member LLC is taxed as a partnership by default and files Form 1065.

An S corporation is not something you form. It is an election you make with the IRS on Form 2553. A corporation or an LLC can make it. Once the election is in effect, the business files Form 1120-S, and its profit passes through to the owners' personal returns on a Schedule K-1.

So the real question is: should my LLC keep its default tax treatment, or elect to be taxed as an S corporation?

What the S election changes

Self-employment tax

Under default treatment, the entire net profit of a sole proprietorship or an active partner's share is subject to self-employment tax (Social Security and Medicare) on top of income tax.

Under an S election, the owner who works in the business must be paid a reasonable salary through payroll. That salary is subject to payroll taxes. The remaining profit is distributed to the owner and is not subject to self-employment tax. The savings come from the gap between total profit and the salary.

A salary you have to justify

"Reasonable compensation" is the phrase that matters. The IRS expects S corporation owner-employees to be paid roughly what someone else would earn doing the same work. Paying yourself a token salary and taking the rest as distributions is the position that gets audited. David reviews the salary each year against the facts of the business.

Payroll and compliance

An S corporation runs payroll, even if the owner is the only employee: pay runs, federal tax deposits, quarterly Form 941, Texas Workforce Commission reports, year-end W-2s. The return itself (Form 1120-S) is more involved than a Schedule C, and there is a separate filing deadline in March. All of this has a cost, which is why the election only makes sense once the savings exceed it.

Basis, distributions and losses

S corporation owners track their stock basis each year. Distributions above basis are taxable, and losses are deductible only to the extent of basis. It is bookkeeping that default LLCs do not need, and it is one more reason to keep clean books from the start.

What does not change

• Liability protection comes from the LLC, not the tax election. Electing S status neither adds to it nor takes it away.
• Texas franchise tax applies to LLCs and corporations alike. Most small businesses fall under the no-tax-due threshold but still have a filing obligation.
• Pass-through treatment. Both a default LLC and an S corporation pass income through to the owners. Neither pays federal income tax at the entity level the way a C corporation does.

When the S election tends to make sense

In broad strokes, the election becomes worth considering when the business produces consistent profit well above what a reasonable salary for the owner would be, when the owner is actively working in the business, and when the business is prepared to run payroll and keep proper books. Below that point, the added compliance usually costs more than it saves.

Businesses with passive income, such as rental real estate, usually do not benefit, because rental income is not subject to self-employment tax in the first place. Businesses planning to raise venture capital often need a C corporation instead.

When to decide

The S election can be made when the business is formed, or later. It generally has to be filed within the first two and a half months of the tax year it should take effect, though the IRS grants relief for late elections in many cases. Converting an existing LLC is a routine project in David's practice.

Run the numbers before you choose

There is no universal answer. The right structure depends on your profit, your role in the business, how many owners there are and where the company is going. David's entity structuring engagement compares the options with your actual numbers, and the first consultation is free.

This article is general information, not advice for your situation. Tax rules change; talk to a CPA before acting.