Why 90% of Founders Ask This Question Wrong
Should I be an LLC or an S corp?
Pankaj Raval and Sahil Chaudry get that question more than any other, and on a recent episode of Letters of Intent they argued that most people asking it are asking the wrong thing entirely.
Sahil put it plainly. It is like asking whether you should drive a BMW or drive stick.
Here is the reframe, the numbers that changed for 2026, and the case that decides how much salary you actually have to pay yourself.
The Category Error
An LLC and an S corporation are not two versions of the same thing. They sit on different layers.
An LLC is a state law entity. You file with the Secretary of State, you get limited liability, and you get an operating agreement that says whatever the owners agree it should say.
An S corporation is a federal tax election. You file Form 2553 with the IRS. That is the entire mechanism.
Which means an LLC can be an S corp
This is the part that breaks people, and it is straightforward once you see it.
Form an LLC in California, file the 2553, and you now have a limited liability company taxed as an S corporation. One entity, two labels. Extremely common.
So the real question is two questions. What legal wrapper do you want, and how do you want that wrapper taxed?
The answer to the first is usually an LLC
The wrapper question is generally the easier one. An LLC is inexpensive, flexible, and its governance document is whatever the partners negotiate.
The tax question is where the analysis actually lives.
What happens if you never elect
You still get an answer. It is simply a default that nobody chose deliberately.
One owner and the IRS disregards the entity entirely, so everything lands on your Schedule C. Two or more owners and you are taxed as a partnership.
Those defaults are perfectly workable. They are just defaults.
What Changed for 2026
Two numbers moved, which is why this conversation reopened.
The wage base
Social Security tax runs 12.4% and applies only to the first slice of earnings. According to the episode, that slice for 2026 is $184,500, up $8,400 from the prior year.
If you are self employed, you pay both halves of it. That is not an abstraction.
The qualified business income deduction
The second change matters more. The One Big Beautiful Bill Act, signed July 4, 2025, made the Section 199A qualified business income deduction permanent.
That deduction had been scheduled to expire at the end of 2025. Anyone running entity analysis in recent years carried an asterisk warning that the whole calculation would change.
Pankaj offered a useful clarification on air. Permanent means the sunset was repealed. It does not mean Congress cannot change it later. It means the provision no longer expires on its own.
Why this matters practically
You can now build a ten year plan around a pass-through structure instead of a two year one.
More broadly, the episode’s framing is worth carrying with you. Your entity structure is not a decision you made once and filed away. It is a position you hold while the tax code keeps moving underneath you.
The S Corporation Guest List
The election comes with eligibility restrictions most founders never see at formation.
No more than 100 shareholders.
Individuals and certain trusts only. Not LLCs, not corporations, with narrow exceptions such as one S corporation wholly owning another.
No non-resident alien shareholders.
One class of stock. Voting and non-voting shares are permitted. Preferred stock with a liquidation preference is not, which means no Series A or Series B in the conventional venture sense.
What happens when you violate one
The election terminates. As Sahil put it, there is no warning letter.
Your company reverts to whatever the default treatment is, which may be a partnership, a sole proprietorship, or a C corporation depending on the wrapper.
That outcome is manageable when the owners are you, a co-founder, and a family member. It is a serious problem on the day a fund wants to invest, because a fund is an entity shareholder and entity shareholders are not permitted.
Worth knowing before you take outside money rather than during the term sheet.
Watch the drift
These restrictions do not announce themselves. An early employee moves abroad and changes residency status. A shareholder puts shares into an entity for estate planning. A founder agrees to preferred terms for one investor.
Each of those is a normal business event, and any of them can terminate the election quietly. Review eligibility annually rather than assuming formation-day compliance still holds.
The Core Mechanic, and Its Limit
Understanding why anyone bothers with this election requires one piece of arithmetic.
As a sole proprietor or partner, your net business income faces self-employment tax at 15.3%. That breaks into 12.4% for Social Security up to the wage base and 2.9% for Medicare with no ceiling, plus an additional 0.9% above certain income thresholds.
Elect S corporation treatment and the company puts you on payroll. Your salary carries employment tax. Distributions beyond that salary do not.
That is the entire pitch. Everything else in this conversation is about the conditions attached to it.
The savings are real. Owners at meaningful profit levels often reduce their tax bill noticeably, which is why accountants raise the election so frequently.
Why a tiny salary does not work
Sahil raised the obvious follow-up during the episode, framed as something a founder might say. Just pay yourself almost nothing in salary and take everything as distributions.
Pankaj’s answer was direct. The IRS does not care what you label a payment. It cares about economic reality.
The Watson Case
David Watson, a CPA in Iowa, held a 25% interest in an accounting firm through an S corporation.
The company paid him a salary of $24,000 a year. In 2002, he took $203,000 in distributions. In 2003, he took $175,000.
His salary was roughly eleven percent of what he actually took home.
What the IRS did
The IRS looked at the arrangement and concluded that it was not a salary. It brought in a valuation expert who used professional survey data and determined the market rate for Watson’s actual work was $91,044.
The district court agreed and recharacterized roughly $67,000 a year as wages. In 2012, the Eighth Circuit affirmed.
The reasoning worth holding on to
The courts said the taxpayer’s intent does not control. The label does not control.
What controls is whether the payment is, in substance, compensation for services actually performed. And courts look at market rates to answer that.
Or as Pankaj summarized it: you cannot paperwork your way out of economic reality.
The working rule
Pay yourself what you would have to pay a stranger to do your job. Then write down how you arrived at that number before anyone asks, rather than afterward.
Contemporaneous documentation means a compensation survey, a board resolution, and an actual employment agreement. That work costs an afternoon, and it is the difference between a conversation and an assessment.
The Optimization Nobody Mentions
Here is the genuinely counterintuitive part, and it is the reason simple online advice about S corps tends to be wrong.
Your W-2 wages are not qualified business income.
So every dollar you move from the distribution column into the salary column is a dollar that shrinks the base of your Section 199A deduction.
Two forces pulling opposite directions
Lower salary saves payroll tax and grows your qualified business income. Higher salary costs payroll tax and shrinks it.
That is a real optimization problem rather than a lower-is-always-better problem, which is exactly how it gets sold online.
Running it properly means modeling both variables together rather than minimizing one. Your accountant should be able to show you the combined effect at several salary levels.
And above the threshold it flips again
Once income passes certain thresholds, the W-2 wage limitation phases in. At that point you may actually need wages on the books to claim the deduction at all.
The episode cited 2026 thresholds of $201,750 for single filers and $403,500 for married filing jointly, with the phase-in range running to $276,750 and $533,500.
Specified service businesses, including law, accounting, consulting, medicine, and financial services, phase out entirely above the top of that range.
The California Layer
California charges you either way, and the structure of the charge differs.
Every entity filing with the Franchise Tax Board owes the $800 minimum franchise tax. LLC, corporation, S corporation, partnership. That floor does not move.
The LLC gross receipts fee
LLCs owe a second charge stacked on top, based on revenue rather than profit.
The episode walked through the tiers: an additional $900 at $250,000 to $500,000 in receipts, $6,000 at $1 million to $5 million, and $11,790 above $5 million.
Note that this applies to gross receipts, not profit. A business investing heavily in growth pays on revenue regardless.
What an S corporation pays instead
California taxes S corporations at 1.5% of net income, with the same $800 floor.
Why the answer genuinely flips
High revenue with thin margins means 1.5% of a small profit number is often the cheaper state bill. High margin with modest revenue may favor the LLC fee.
You have to run both. There is no rule of thumb that survives contact with actual numbers.
The Los Angeles addition
Businesses engaged in business within the City of Los Angeles also register with the Office of Finance and pay a gross receipts based tax, with rates varying by business classification.
Location matters here, though not as simply as it might appear. The city taxes businesses engaged in business within its limits, so a nominal address elsewhere does not necessarily resolve it. Worth a real conversation rather than a quick fix.
One Thing to Know Before You Elect
The episode closed on a point that belongs in every entity conversation.
Stock issued by an S corporation can never be qualified small business stock. Not with planning, not with restructuring at the last minute. Never.
For the right company, that is a seven figure difference at exit.
Pankaj Raval and our team at Carbon Law Group work through these decisions with Los Angeles business owners, including entity formation, S corporation elections, reasonable compensation documentation, and the structural questions that determine what happens when you eventually raise money or sell.
We ask for financials and projections, because the honest answer depends on your actual numbers rather than a general rule.
If you are choosing a structure or wondering whether your current one still fits, contact Carbon Law Group at carbonlg.com. Bring your revenue, your margin, and your plans for the next few years. That is what the analysis actually requires.
Carbon Law Group’s links: https://linktr.ee/carbonlawgroup