LLC, S Corp or C Corp: How to Choose a Business Structure

Choosing a legal structure is one of the first decisions you make when starting a business, and one of the most confusing. Friends recommend an LLC, an accountant mentions an S corp, and investors talk about Delaware C corporations.

Part of the confusion is that these labels describe different things. An LLC and a corporation are types of legal entity created under state law. S corp and C corp describe how a corporation, or in some cases an LLC, is taxed under federal law. This guide untangles the options.

Key takeaways

• LLCs and corporations both generally protect owners’ personal assets from business debts and lawsuits.
• An LLC is flexible and simple to run, and by default its profits pass through to the owners’ tax returns.
• An S corp is a tax election, not a type of entity. It can reduce self-employment taxes for some profitable businesses, but it has strict ownership rules.
• A C corp pays its own corporate tax and is the standard choice for startups seeking venture capital.
• The right choice depends on your profits, your plans for investment and how much administration you can handle.

First, why form an entity at all?

If you start doing business on your own without forming an entity, you are a sole proprietor by default (or a general partnership if there are two or more of you). That’s simple and cheap, but there is no legal separation between you and the business. If the business is sued or can’t pay its debts, your personal savings, home and other assets may be at risk.

Forming an LLC or corporation creates a separate legal “person.” As long as you respect that separation, the owners are generally not personally liable for the business’s debts. That protection isn’t absolute: owners remain responsible for their own wrongdoing and for debts they personally guarantee, and courts can “pierce the veil” when an entity is treated as an alter ego of its owners.

The limited liability company (LLC)

An LLC is created by filing articles of organization (sometimes called a certificate of formation) with the state. Owners are called members.

Advantages

• Limited liability for members
• Flexible management: run by the members themselves or by appointed managers
• Few required formalities compared with corporations; for example, there’s generally no requirement for annual shareholder meetings
• Flexible profit sharing, which can be set in the operating agreement
• Flexible taxation

How LLCs are taxed by default

• A single-member LLC is treated as a “disregarded entity.” Profits and losses are reported on the owner’s personal return, much like a sole proprietorship.
• A multi-member LLC is taxed as a partnership. The LLC files an informational return and each member reports their share of profit.

Either way, the LLC itself doesn’t usually pay federal income tax. Members pay income tax on their share of profits whether or not the money is distributed, and active members generally pay self-employment tax on those earnings too.

An LLC can also elect to be taxed as an S corp or C corp, which is where the terms start to overlap.

Downsides

• Some states charge high annual fees or franchise taxes for LLCs.
• Most venture capital investors prefer not to invest in LLCs.
• Self-employment tax can be significant for profitable businesses.

A well-drafted operating agreement is essential, particularly when there is more than one member.

The S corporation

An S corporation is a corporation, or LLC, that has elected to be taxed under Subchapter S of the Internal Revenue Code by filing IRS Form 2553.

How it’s taxed

Like a default LLC, an S corp is a pass-through entity: profits and losses flow to the owners’ personal returns, and the company generally doesn’t pay federal income tax itself.

The main attraction is the treatment of self-employment taxes. Owners who work in the business must pay themselves a reasonable salary, which is subject to payroll taxes. Remaining profits can be distributed without self-employment tax. For a profitable business, this can produce meaningful savings. The IRS scrutinizes salaries that are set unreasonably low.

Restrictions

To qualify, the company must meet strict rules, including:

• No more than 100 shareholders
• Shareholders must generally be U.S. citizens or residents, and certain trusts and estates. Partnerships, most corporations and nonresident aliens can’t be shareholders
• Only one class of stock, which limits how profits can be split

Downsides

• Running payroll and filing a separate return adds cost
• The ownership rules make it unsuitable for many investors
• Distributions must be proportional to ownership

The C corporation

A C corporation is the standard corporation, taxed under Subchapter C. It’s formed by filing articles of incorporation and is governed by a board of directors elected by shareholders.

How it’s taxed

A C corp pays federal corporate income tax on its profits, currently at a flat 21% rate. If profits are then paid out as dividends, shareholders pay tax on them again. This is the well-known “double taxation.”

In practice, many growing companies reinvest profits rather than pay dividends, which reduces the impact. Certain C corp stock may also qualify for significant tax benefits on sale under the qualified small business stock rules in Section 1202 of the tax code, if strict requirements are met.

Advantages

• Unlimited shareholders, including foreign individuals and other companies
• Multiple classes of stock, such as the preferred stock investors expect
• The standard structure for venture capital and for eventually going public
• Familiar structure for stock option plans

Downsides

• Double taxation on distributed profits
• More formalities: bylaws, board meetings, minutes and shareholder meetings
• Losses stay in the company and can’t be used on owners’ personal returns

Many startups incorporate in Delaware because of its well-developed corporate law and specialized business court, even if they operate elsewhere. That usually means registering to do business in your home state too.

Side-by-side comparison

Which structure fits you?

These are general patterns, not rules:

• Freelancers and small service businesses often start as an LLC for simplicity and liability protection.
• Profitable small businesses with owners who work in the business, often once profits comfortably exceed a reasonable salary, may consider an S corp election to save on self-employment tax.
• Startups planning to raise venture capital or issue stock options usually form a C corporation from the start, often in Delaware.
• Real estate investors often use LLCs because of their flexibility and pass-through treatment.

Your choice isn’t always permanent. LLCs can change their tax classification, and businesses can convert from one type of entity to another, although conversions can have tax consequences.

Frequently asked questions

Is an S corp better than an LLC?

Not inherently. An LLC can elect S corp taxation, so the question is usually whether the tax savings outweigh the added cost of payroll and compliance. That depends on your profits and should be run by a tax professional.

Do I need a lawyer to form an LLC?

You can file the formation documents yourself. A lawyer adds value in drafting the operating agreement, especially with multiple owners, and in deciding how to structure ownership, vesting and buyouts.

Which state should I form my business in?

For most small businesses that operate in one state, forming in your home state is simplest and cheapest. Forming elsewhere usually means registering as a foreign entity at home and paying fees in both states.

Does an LLC protect me if I personally make a mistake?

No. Limited liability protects you from the business’s debts and from others’ actions, but not from your own negligence or wrongdoing, or from debts you personally guarantee.

When to talk to a lawyer and an accountant

Entity choice sits at the intersection of law and tax. It’s worth a consultation with a business attorney and a CPA if you have co-founders, plan to raise money, expect significant profits, have foreign owners, or are converting an existing business. A little advice at the start is far cheaper than restructuring later.