Choosing to have your LLC taxed as an S Corp sounds like a smart move—after all, who wouldn’t want to save on self-employment taxes? But before you make the switch, it’s crucial to understand the hidden drawbacks. From increased IRS scrutiny to complex payroll requirements and state tax surprises, an S Corp election isn’t always the golden ticket, it seems.
In this article, we’ll break down the disadvantages of an LLC taxed as an S Corp so you can make an informed decision and avoid costly mistakes.
Disadvantages of LLC Taxed as S Corp
When business owners hear about the potential tax savings of electing S Corporation status for their LLC, they often jump at the opportunity. Reducing self-employment taxes sounds great, but what many don’t realize is that an LLC taxed as an S Corp comes with strict rules, added costs, and hidden risks that could outweigh the benefits. If you’re considering this election, you need to know the downsides before making the switch.
1. Increased Tax Compliance and Paperwork
One of the biggest advantages of an LLC is its simplicity—owners report profits and losses on their personal tax returns without filing a separate business tax return. But once you elect S Corp status, that simplicity vanishes.
Now, instead of filing a straightforward Schedule C, your business must file:
Form 1120-S – The corporate tax return for S Corps
Schedule K-1 – Reporting each owner's share of income
Payroll Filings – Since S Corp owners must take a salary, payroll taxes must be withheld and reported
All of this means more paperwork, more deadlines, and higher accounting fees. If you’re not prepared to handle the added compliance, an S Corp could quickly become a hassle.
2. The “Reasonable Salary” Rule—And Why It’s a Trap
A major reason business owners choose S Corp taxation is to reduce self-employment taxes by splitting income into two categories:
- Wages (subject to payroll taxes)
- Distributions (not subject to payroll taxes)
Sounds great, right? Not so fast. The IRS has strict rules about reasonable compensation, meaning you can’t just pay yourself a tiny salary and take the rest as distributions to avoid taxes.
If your salary is too low, the IRS can reclassify your distributions as wages, hitting you with back taxes, penalties, and interest. In other words, if you think you can “game the system,” think again—the IRS is watching closely.
To stay compliant, you’ll need to:
✔ Research industry salary standards for your role
✔ Justify your salary based on business revenue
✔ Document everything to defend yourself in case of an audit
This adds another layer of complexity and risk that standard LLCs don’t have to deal with.
3. Higher Operating Costs and Fees
Switching to an S Corp isn’t free—and in many cases, the costs outweigh the tax savings. Here’s why:
- Payroll Costs – Since you’re now an “employee” of your LLC, you need a payroll system, which comes with setup and processing fees.
- Bookkeeping & Accounting Fees – S Corp tax returns are more complicated and expensive than a simple LLC tax filing. Expect to pay a CPA more for tax preparation.
- State Franchise Taxes – Some states charge extra fees to S Corps. For example, California has a $800 minimum franchise tax, regardless of profits.
So, while an S Corp can reduce self-employment tax, you need to make sure the savings exceed the added costs. If your business isn't generating consistent, significant profits, you might end up paying more than you save.
4. Less Flexibility in Profit Distribution
If your business has multiple owners, electing S Corp status could create frustrating limitations. Unlike a standard LLC, where you can divide profits however you want, an S Corp must distribute profits strictly based on ownership percentage.
For example:
In an LLC, one owner could take 70% of profits while another takes 30%, even if they own equal shares.
In an S Corp, if two owners each hold 50%, they must receive equal distributions, even if one contributed more to the business.
This rigidity can make tax planning and profit-sharing much more complicated, potentially leading to conflicts among business partners.
5. The IRS Pays Extra Attention to S Corps
If you don’t want the IRS scrutinizing your business, an S Corp election might not be the best move. The IRS closely monitors S Corps for abuse, particularly when it comes to:
- Owners underpay themselves to avoid payroll taxes
- Classifying personal expenses as business deductions
- Failing to properly file payroll tax forms
Since S Corps are known for being used as tax shelters, the IRS audits them more frequently than standard LLCs. If your filings aren’t airtight, you could find yourself facing an expensive audit.
6. State-Level Tax Surprises
Even if electing S Corp taxation seems beneficial on a federal level, state tax laws can throw a wrench into your plan. Some states don’t recognize S Corps at all, while others impose extra fees and taxes.
Here are a few examples:
- California: Imposes an $800 minimum franchise tax on S Corps, even if your business isn’t profitable.
- Tennessee & New Hampshire: Tax S Corp income at the state level, reducing potential tax savings.
- New York: Requires additional S Corp election at the state level, adding more bureaucracy.
Before electing S Corp status, check your state’s tax laws—otherwise, you might end up paying more than you save.
7. Risk of Losing the Qualified Business Income (QBI) Deduction
One of the biggest tax benefits for LLC owners is the 20% Qualified Business Income (QBI) deduction, which reduces taxable income. However, switching to an S Corp can limit or eliminate this benefit.
Here’s why:
LLC owners get the full QBI deduction on their entire business profit.
S Corp owners must subtract their salary before calculating the deduction.
For example:
- If your LLC earns $100,000, you could get a $20,000 QBI deduction (20% of total profits).
- If your S Corp earns $100,000, but you take a $50,000 salary, your QBI deduction only applies to the remaining $50,000, cutting your tax benefit in half.
If your goal is maximizing tax deductions, electing S Corp status might reduce your total savings instead of increasing them.
8. Inflexibility if Business Profits Fluctuate
One of the biggest advantages of an LLC is flexibility—you can adjust how much you take in owner draws based on your business’s performance. But once you elect S Corp status, you’re locked into paying yourself a salary, even if your revenue dips.
This means:
In slow months, you still must process payroll and pay payroll taxes.
If your business loses money, you might struggle to cover salary obligations.
Unlike an LLC, where you can simply pause owner draws, an S Corp requires
consistent payroll payments.
If your business income fluctuates significantly, an S Corp can add unnecessary financial stress instead of tax relief.
9. Potential Difficulties When Selling the Business
If you ever decide to sell your business, having an S Corp structure can complicate the process compared to a regular LLC.
LLCs offer more flexibility in structuring a sale, allowing buyers to purchase membership interests or just business assets.
S Corps has restrictions—potential buyers must meet S Corp eligibility requirements, limiting potential buyers.
This can make selling your business harder and less attractive to investors, especially if they don’t want to deal with S Corp limitations.
Should You Elect S Corp Status for Your LLC?
After breaking down the hidden disadvantages of an LLC taxed as an S Corp, the big question remains: Is it the right move for your business?
An S Corp might be a good choice if:
- Your business consistently makes over $50,000 in profit.
- You’re comfortable handling payroll compliance.
- You want to reduce self-employment tax and are willing to pay yourself a reasonable salary.
You should think twice if:
- Your income fluctuates, and you may struggle to pay yourself a consistent salary.
- You want flexibility in profit distribution (especially with multiple owners).
- You prefer simpler tax filings with fewer compliance headaches.
Summary
Electing S Corp status can save money—but only for the right businesses. For many LLC owners, the added complexity, costs, and restrictions outweigh the benefits. Before making the switch, run the numbers carefully and consider whether you’re ready for the increased compliance burden.
If you're unsure, consult a tax professional from NJCPA USA to see if the savings justify the effort. Otherwise, sticking with a traditional LLC may be the smarter move in the long run.
