The entity choice question gets asked at every kitchen table where someone is about to start a business. The honest answer is that for most early-stage businesses, the difference between an LLC and an S-corp is small, the difference between either and a C-corp is large, and the question is less about taxes than about who you plan to take money from.
Here is the practical framework.
What each one is
LLC: a limited liability company is a state-law entity that gives you liability protection without the formality of a corporation. The IRS does not have an LLC tax category, so an LLC defaults to being taxed as a sole proprietorship (single member), partnership (multi-member), or any entity it elects to be (S-corp, C-corp).
S-corporation: an IRS tax election available to corporations and LLCs that meet certain requirements. The entity itself pays no federal income tax; income passes through to the owners and is taxed at their individual rates. S-corp status requires 100 or fewer shareholders, all U.S. persons, and only one class of stock.
C-corporation: a corporation taxed as a separate entity. The corporation pays corporate income tax on its profits, and shareholders pay personal tax on dividends, the famous double taxation. C-corps have no restrictions on number of shareholders, type of shareholders, or classes of stock.
The first thing to understand: LLC is a legal structure. S-corp and C-corp are tax statuses. An LLC can elect to be taxed as an S-corp or a C-corp. A corporation can elect to be taxed as an S-corp. You can mix and match.
When LLC default taxation is the right answer
For most early-stage businesses with one to a handful of owners, all of whom are actively involved, the LLC with default taxation is the right structure.
Why:
- Simple formation. State filing plus operating agreement. No corporate formalities (annual meetings, board minutes, share certificates).
- Pass-through taxation. No entity-level tax. Profits and losses flow to the owners and are taxed at their individual rates.
- Flexible ownership. Multiple classes of membership interests, profit allocations that do not match ownership percentages, foreign or entity owners, all allowed.
- Flexible profit distributions. Distributions to members can be made on any schedule.
The LLC is the default for most service businesses, single-product startups, real estate holdings, and family businesses.
When S-corp election makes sense
The S-corp election (whether layered onto an LLC or a corporation) is primarily a self-employment tax strategy.
Here is how it works: in an LLC taxed as a partnership or disregarded entity, all profit flowing to an active owner is subject to self-employment tax (15.3 percent up to the Social Security wage base, 2.9 percent above it, plus an additional 0.9 percent Medicare surtax for high earners).
In an LLC taxed as an S-corp, the owner takes a reasonable salary (subject to payroll tax) and the rest of the profit is taken as a distribution (no payroll tax). On profits above the reasonable-salary threshold, you save 15.3 percent (subject to the Social Security wage base) or 2.9 percent (above it) per dollar.
The savings start to matter when net profit per owner is above roughly $50,000 to $80,000 per year, depending on the reasonable-salary calculation. Below that, the cost of running payroll and filing the additional returns ($800 to $2,000 per year) eats the savings.
S-corp downsides:
- Restrictive ownership. All U.S. persons, 100 or fewer shareholders, one class of stock.
- Reasonable compensation requirements. The IRS scrutinizes S-corp owner salaries; setting them too low to maximize distributions invites audit.
- Less flexible distributions. S-corp distributions must be in proportion to ownership.
- Payroll setup. You have to run payroll, which adds cost and complexity.
For a single owner pulling $200,000 in net profit from a service business, the S-corp election usually pays off. For a real estate LLC with passive income, the election usually does not (passive income is not subject to self-employment tax anyway).
When C-corp is the right answer
C-corp is the right answer in one specific scenario: you are raising venture capital, plan to grant equity to a meaningful number of employees, and expect to either exit through an acquisition or eventually go public.
Why VC investors require C-corp:
- Preferred stock. Most VC investments use preferred stock with liquidation preferences, anti-dilution protection, and other features. S-corp one-class-of-stock rule prohibits this. LLC operating agreements can mimic preferred-stock economics, but the structure is unfamiliar to most VC firms.
- Stock options. Standard ISO and NSO option plans are designed for C-corp stock.
- Tax treatment for institutional investors. Many institutional VC investors are tax-exempt entities (university endowments, pension funds) that face unrelated business taxable income (UBTI) issues with pass-through entities.
- Section 1202 (qualified small business stock). A C-corp shareholder who holds stock for five years may exclude up to $10 million of gain from federal tax on sale, if the C-corp meets certain requirements. This is a meaningful incentive for founders and early employees.
C-corp downsides:
- Double taxation. Corporate income tax (21 percent federal) plus personal tax on dividends. Most VC-backed startups address this by reinvesting all earnings and not paying dividends, but the structure is still less tax-efficient than pass-through for businesses that intend to distribute earnings.
- Formalities. Board of directors, annual meetings, formal stock issuances, board approval for major decisions.
- Higher accounting cost. Corporate tax return is more complex than partnership return; corporate audits if you are funded.
For a startup not planning to raise VC, C-corp is almost never the right answer.
The framework
A short heuristic:
- Service business with one to four active owners, not planning to raise VC: LLC, default taxation. If net profit exceeds $80,000 per owner, evaluate S-corp election.
- Single-owner consulting practice with high net profit: LLC with S-corp election.
- Real estate or passive income: LLC, default taxation. S-corp does not save anything on passive income.
- Startup planning to raise VC: C-corp (Delaware).
- Family business with multiple owners and different roles: LLC, default taxation. The flexibility of LLC profit allocation handles different roles well.
When to revisit
The entity choice is not permanent. You can:
- Convert an LLC to a corporation by filing a state conversion.
- Elect S-corp status on an existing LLC or corporation by filing IRS Form 2553.
- Revoke S-corp status (and revert to LLC default or C-corp) by filing a revocation.
Reasonable times to revisit:
- Net profit crosses the $80,000-per-owner threshold (consider S-corp).
- You start fundraising from outside investors (consider C-corp conversion).
- You add owners with significantly different roles (consider LLC structure).
- Tax law changes that affect the comparison.
If you are at the entity-choice decision or considering a conversion, LawSensai can match you with a business attorney in your state.