Choosing the right business structure is an important decision for any business owner. The entity you choose can affect how your business is taxed, how you pay yourself, your administrative responsibilities, your ability to bring in investors, and the level of legal separation between you and your business.
Three terms business owners frequently hear are LLC, S Corporation, and C Corporation. Although these terms are often discussed as if they are three completely different types of businesses, there is an important distinction:
An LLC is a legal business structure, while S Corporation and C Corporation generally describe how a business is taxed for federal income tax purposes.
For example, a business can legally be organized as an LLC while electing to be taxed as an S Corporation.
Understanding this distinction can make choosing a business and tax structure much easier.
What Is an LLC?
An LLC, or Limited Liability Company, is a business entity created under state law.
One of the primary reasons business owners form an LLC is to create legal separation between themselves and their business. When properly established and maintained, an LLC generally provides its owners with limited liability protection, although that protection is not absolute.
Another major advantage of an LLC is flexibility.
For federal income tax purposes, an LLC can potentially be treated in several different ways depending on the number of owners and elections made by the business.
A single-member LLC is generally treated as a disregarded entity for federal income tax purposes unless another tax election is made. For an active business, income and expenses may generally be reported on Schedule C of the owner's individual income tax return.
An LLC with two or more members is generally taxed as a partnership unless it elects another tax classification.
An eligible LLC can also elect to be taxed as an S Corporation or C Corporation.
Example: Single-Member LLC
Suppose Sarah starts a bookkeeping business called Sarah Accounting LLC.
Her business has:
Annual revenue: $100,000
Business expenses: $40,000
Net business profit: $60,000
If Sarah is the only owner and has not made a corporate tax election, the LLC would generally be treated as a disregarded entity for federal income tax purposes.
For an active bookkeeping business, the $60,000 profit would generally be reported through Schedule C on Sarah's individual income tax return.
In addition to income tax, Sarah may also owe self-employment tax on the business's net earnings, subject to applicable tax rules.
When Can an LLC Be Beneficial?
An LLC can be attractive for new and small businesses because it combines liability protection with considerable tax flexibility.
It may be appropriate for businesses such as:
- Consulting companies
- Bookkeeping and accounting businesses
- Cleaning companies
- Landscaping businesses
- Contractors
- Online businesses
- Small retail businesses
- Real estate businesses
Another advantage is that an LLC does not necessarily need to change its legal structure if the owner later decides that S Corporation taxation makes sense.
The LLC can potentially remain an LLC under state law while changing its federal tax treatment.
What Is an S Corporation?
An S Corporation, commonly called an S Corp, is primarily a federal tax status rather than simply another type of LLC.
A corporation can elect S Corporation status, and an eligible LLC can also elect to be taxed as an S Corporation.
One reason business owners consider S Corporation taxation is the treatment of compensation and business income.
An owner who actively works for an S Corporation generally must receive reasonable compensation for the services the owner provides.
That compensation is generally paid as W-2 wages and is subject to applicable payroll taxes.
After reasonable compensation and other business expenses are considered, remaining S Corporation income generally passes through to the shareholder's individual income tax return and generally is not subject to self-employment tax.
Example: LLC Taxed as an S Corporation
Suppose Sarah's accounting business grows significantly.
The business now generates:
Revenue: $250,000
Operating expenses before owner compensation: $100,000
Profit before owner compensation: $150,000
Sarah's LLC elects to be taxed as an S Corporation.
Assume that reasonable compensation for the work Sarah performs is determined to be $80,000.
In a simplified example:
Profit before owner compensation: $150,000
Sarah's salary: $80,000
Remaining profit before considering employer payroll taxes and other adjustments: $70,000
Sarah's $80,000 salary would generally be subject to applicable payroll taxes.
The remaining S Corporation income would generally pass through to Sarah and would generally not be subject to self-employment tax.
This distinction can create potential payroll-tax savings in appropriate circumstances.
However, S Corporation status also creates additional responsibilities, including payroll processing, payroll tax filings, corporate tax preparation, bookkeeping requirements, and other compliance obligations.
The Reasonable Compensation Rule Matters
Business owners should not assume that S Corporation status allows them to eliminate payroll taxes by taking very little salary and withdrawing most of the business income as distributions.
An owner who performs substantial services for the S Corporation generally must receive reasonable compensation before taking non-wage distributions.
For example, if an owner performs full-time professional services for a company generating substantial profit, paying the owner only a very small salary simply to reduce payroll taxes may create tax compliance concerns.
When Can an S Corporation Be Beneficial?
S Corporation taxation may be worth evaluating when a business:
- Generates consistent profits
- Has an owner who actively works in the business
- Can support reasonable owner compensation
- Has enough remaining profit after reasonable compensation to potentially justify the additional administrative costs
- Meets the eligibility requirements for S Corporation taxation
There is no universal profit level at which every business should become an S Corporation. The potential tax savings should be compared with payroll expenses, accounting costs, tax preparation fees, administrative responsibilities, and the owner's individual circumstances.
What Is a C Corporation?
A C Corporation is generally a corporation taxed separately from its owners under Subchapter C of the Internal Revenue Code.
Unlike an S Corporation, which generally passes taxable income through to its shareholders, a C Corporation generally pays federal corporate income tax on its own taxable income.
The corporation generally files Form 1120, U.S. Corporation Income Tax Return.
If the corporation later distributes after-tax earnings to shareholders as taxable dividends, shareholders may also owe tax on those dividends.
This creates what is commonly called double taxation.
Example: C Corporation
Suppose XYZ Corporation generates:
Taxable income: $1,000,000
Assuming a 21% federal corporate income tax rate:
Federal corporate income tax:
$1,000,000 × 21% = $210,000
Remaining income after federal corporate income tax:
$790,000
If the corporation retains those earnings to finance business operations or expansion, shareholders do not automatically owe dividend tax simply because the corporation earned the income.
However, if the corporation distributes after-tax earnings to shareholders as taxable dividends, the shareholders may also owe tax on those dividends.
Therefore, C Corporation earnings can potentially face taxation at two levels:
Level 1: Corporate income tax
The corporation pays tax on its taxable income.
Level 2: Shareholder tax
Shareholders may pay tax when after-tax corporate earnings are distributed as taxable dividends.
LLC vs. S Corporation vs. C Corporation
Here is a simplified comparison:
| Feature | LLC – Default Taxation | S Corporation | C Corporation |
|---|---|---|---|
| Legal structure or tax status? | Legal structure | Tax status | Corporate tax structure |
| Limited liability protection | Generally yes | Generally yes | Generally yes |
| Pass-through taxation | Generally yes | Yes | Generally no |
| Separate federal corporate income tax | Generally no | Generally no | Yes |
| Owner can generally receive W-2 wages | Not as owner of a disregarded LLC | Yes | Yes |
| Potential payroll-tax planning | Limited | Yes, subject to reasonable compensation | Different corporate/employee structure |
| Ownership flexibility | Relatively flexible | More restricted | Highly flexible |
| Multiple classes of stock | Not applicable in the traditional corporate sense | Generally no | Yes |
| Common federal filing | Schedule C or Form 1065 | Form 1120-S | Form 1120 |
| Administrative complexity | Usually lower | Moderate | Generally higher |
Which Structure May Make Sense?
There is no single business structure that is best for every business.
The appropriate structure depends on the company's profitability, number and type of owners, industry, growth plans, payroll needs, investment strategy, financing needs, and long-term goals.
Example 1: A New Landscaping Business
John starts a landscaping company and expects approximately $60,000 in annual net profit.
A single-member LLC with default federal tax treatment may provide a relatively straightforward starting structure while giving John the benefits of operating through a separate legal entity.
As the business grows, John can revisit whether another tax classification would be beneficial.
Example 2: A Profitable Accounting Firm
Maria owns an accounting firm generating substantial and consistent annual profit.
She actively works in the company.
An LLC taxed as an S Corporation may be worth evaluating because Maria could receive reasonable W-2 compensation while qualifying remaining business income may pass through without being subject to self-employment tax.
However, the potential tax savings should be compared with the additional cost and complexity of payroll, accounting, tax preparation, and compliance.
Example 3: A Growing Technology Company
Three entrepreneurs create a technology startup.
Their long-term plan includes raising outside capital, bringing in investors, issuing equity compensation to employees, potentially creating different classes of stock, and eventually selling the company or going public.
A C Corporation may better accommodate this type of ownership and investment structure.
Certain qualifying C Corporation shareholders may also potentially benefit from Qualified Small Business Stock (QSBS) provisions under Internal Revenue Code Section 1202, subject to detailed eligibility requirements.
Legal Structure and Tax Structure Are Two Different Decisions
One of the most important concepts for business owners to understand is that choosing a legal entity and choosing a tax classification are not always the same decision.
Think about the process as two separate questions.
Question 1: What legal entity should the business use?
For example:
LLC
or
Corporation
Question 2: How should that entity be taxed?
Depending on eligibility and elections, the possibilities may include:
Single-Member LLC → Disregarded Entity
Multi-Member LLC → Partnership
LLC → S Corporation Taxation
LLC → C Corporation Taxation
Corporation → C Corporation Taxation
Corporation → S Corporation Taxation
This distinction is particularly important when discussing S Corporations.
A business owner may hear that they should "change their LLC into an S Corp."
That is not always what actually happens.
In many situations, the business can remain an LLC under state law while electing to be taxed as an S Corporation for federal tax purposes.
Final Considerations
Choosing between an LLC, S Corporation taxation, and a C Corporation should not be based solely on which structure appears to have the lowest tax rate.
Business owners should consider the complete picture, including:
- Federal and state taxation
- Self-employment and payroll taxes
- Reasonable compensation requirements
- Liability protection
- Number and type of owners
- Administrative costs
- Accounting and payroll requirements
- Ownership restrictions
- Future investors
- Financing needs
- Business growth plans
- Exit strategy
A structure that works well for a new business may no longer be the most appropriate structure as the company grows.
For this reason, business owners should periodically review their business and tax structure with qualified accounting, tax, and legal professionals.
Disclaimer
This article is intended for general educational and informational purposes only. It does not constitute tax, accounting, financial, or legal advice. Tax laws and business regulations are complex and may change, and the appropriate business structure depends on the specific circumstances of each business and its owners. Business owners should consult qualified tax, accounting, and legal professionals before forming an entity, making a tax election, or changing an existing business structure.