LLC vs. S‑Corp vs. C‑Corp: choosing the right entity

Ask ten owners which entity they should use and most will describe the choice as LLC versus S‑Corp. It is the standard framing, and it contains a mistake that makes the decision harder than it needs to be.

This article separates the pieces, explains how each option is taxed, and gives you a way to tell which fits your business now.

The two questions people conflate

What your business legally is gets decided at the state level: sole proprietorship, partnership, LLC, or corporation. That choice governs liability, ownership rights, and what you owe your state each year.

How your business is taxed gets decided federally, as a separate classification: disregarded entity, partnership, S‑corporation, or C‑corporation.

The two are only loosely linked. An LLC can be taxed as any of the four, and “S‑Corp” is not something you form, it is something you elect. Choose the entity for liability and state cost, the classification for the tax math, and revisit the second far more often than the first.

Owners come to us asking whether they should be an LLC or an S‑Corp. The question has a hidden assumption in it, that these are alternatives. They are not. Most of our clients are an LLC that is taxed as an S‑corporation. Ali Kafoo, CPA

The LLC and its default tax treatment

An LLC is formed by filing with a state. It gives you limited liability, flexible ownership, and an operating agreement that can fit almost any arrangement between owners. Federally it has no classification of its own, so the IRS applies a default based on how many owners it has.

Single‑member LLC: disregarded entity

The IRS looks straight through to you. Activity is reported on your personal return, Schedule C for an operating business, Schedule E for rental property, with no separate business return.

Multi‑member LLC: partnership

The LLC files an information return and issues a K‑1 to each member, who reports their share personally. Partnership treatment is more flexible than owners expect: profit and loss can be allocated in ways that do not track ownership percentages, which matters wherever partners contribute unequally.

The limitation in both defaults is identical. Your share of active profit carries self‑employment tax in full, and you are taxed on it whether or not you took it out.

The S‑corporation election

An S‑corporation is a tax election, made on a form filed with the IRS. Your LLC stays an LLC, and state registration, operating agreement, and liability protection are untouched.

What changes is how profit reaches you. You become an employee of your own business and take a reasonable salary through payroll, which carries employment taxes. Profit above that salary is distributed free of self‑employment tax. That is the whole savings mechanism, worked through in what the S‑Corp election actually saves.

The election adds permanent cost: payroll, a separate return, basis tracking, documented compensation. It adds restrictions too, notably a capped shareholder count and a single class of stock. Those rarely trouble an owner‑operated business, and they become disqualifying the moment you want institutional money.

The C‑corporation and entity‑level tax

A C‑corporation is the only one of the three that is a separate taxpayer. It files its own return and pays tax on its own profit, and nothing reaches your personal return until money moves.

When it moves as a dividend, it is taxed again in your hands. That is the double taxation everyone warns about. What the warning leaves out is that salary paid to owner‑employees is deductible, so only dividends carry the second layer.

Three situations make it the right answer anyway.

You are reinvesting profit rather than taking it

A pass‑through owner is taxed on profit whether or not they take it out. A C‑corporation owner is not. For a capital‑intensive business plowing earnings back in, the corporate rate on retained profit can cost less than personal rates on money that never reached you.

You are raising institutional capital

Venture funds, foreign investors, and most entities cannot be S‑corporation shareholders, and preferred stock requires more than one class. Pass‑through income also creates problems for a fund’s tax‑exempt partners.

You may qualify for special stock treatment

Stock in certain small corporations, acquired at original issuance and held for a required period, can qualify for favorable treatment on the eventual gain. For a founder building toward an exit it can be the largest number in the analysis, and it is available only on corporate stock.

What liability protection actually protects

Owners often choose an entity for the liability shield, then operate in a way that undermines it. Filing creates the shield; conduct maintains it. Courts set the protection aside, piercing the veil, for reasons that are consistent and avoidable:

• Commingling funds. Personal expenses on the business card, business bills paid personally, no clear line between the two. By far the most common reason.
• Undercapitalization. An entity formed with no meaningful funding and never capitalized enough to meet its foreseeable obligations.
• Ignoring formalities. No operating agreement, no minutes where required, lapsed annual reports, contracts signed in your own name.

Two things no entity protects against. Personal guarantees are voluntary, and a lender holding one can reach you directly. And your own acts, negligence, fraud, remain yours.

The comparison, side by side

What your state does to the math

Federal treatment is only part of the cost. States impose franchise taxes, minimum annual taxes, fees scaled to gross receipts, and sometimes entity‑level taxes owners do not expect. A structure that is correct federally can be expensive in a particular state.

Not every state respects the S‑election the way the IRS does, either. Many now offer a pass‑through entity tax election, worth real money to owners limited by the cap on state and local tax deductions.

Washington is unusual. With no personal or corporate income tax, the entity decision here is driven almost entirely by federal treatment. What replaces it is the business and occupation tax, on gross receipts rather than profit.

How the right answer changes as you grow

Structure is a decision with a shelf life. What fits a business at $150,000 of revenue rarely fits it at $2 million.

1. Getting started. An LLC under default treatment. Low cost, minimal formality, real protection. Adding complexity before there is profit to protect is waste.
2. Consistently profitable. When profit reliably exceeds a reasonable salary for your role, run the S‑election math. Not before, the added cost is permanent.
3. Reinvesting heavily or raising capital. Where the C‑corporation conversation turns serious. Make it deliberately, not under deal pressure.

An annual structure review is inexpensive and occasionally very valuable. It belongs alongside your projections, which is how we handle it in our tax optimization work. For how structure and reporting interact across entities, see our investment firm case study.

Changing structure later, and what it costs

You can change, and most growing businesses do. Changing tax classification is the easy end: an LLC electing S‑corporation treatment files a form, subject to timing deadlines, and keeps everything else. That is why it is the most common move by a wide margin.

Converting the legal entity is harder. Most states have a conversion statute that turns an LLC into a corporation without dissolving anything, and it can often be done without immediate tax, but appreciated assets and prior losses need attention first.

Some moves carry a waiting period. Revoking an S‑election generally means a multi‑year wait before electing again, and a C‑corporation that later elects S‑status can face tax on gains built in before conversion.

Then there is the administrative tail: possibly a new EIN, new bank accounts, updated contracts, and re‑registration in each state where you operate. Budget weeks, not an afternoon.

The honest summary: most owner‑operated businesses end up as an LLC, taxed as a partnership or disregarded entity early on, electing S‑corporation treatment once profit justifies it. The C‑corporation is right for an identifiable minority, and you generally know if you are in it.

If you are not sure, that is a short conversation with a clear answer. Schedule a consultation and we will look at your profit, your state, and where you are heading. Related reading: quarterly estimated taxes.

Frequently asked questions