Are you starting a business and wondering how to legally structure your business? According to the US Small Business Administration (SBA), about 600,000 new businesses are started each year. If you are starting a new business, it’s important to set it up using the appropriate entity that correlates with your goals for liability and taxation, so that you can effectively finance, grow, and operate your business. While all three types offer limited liability, we’ll cover other similarities and differences between a limited liability company (LLC), C corporation (C corp), and S corporation (S corp) so that you can choose the proper structure for your business.

A key aspect to understand when discussing the differences between these three types of structures is the concept of double taxation. Double taxation occurs when company profits are first taxed at the corporate level and then again at the personal level when the owner receives a salary from the business.

Limited Liability Company

A limited liability company, commonly abbreviated LLC, is a legal entity that protects its owner(s) from personal responsibility for the company’s debt or other liabilities. If your business goes under, you owe money, or the business is sued, your personal assets not tied to the company are safe. According to Investopedia, “an LLC allows pass-through taxation, meaning business income or losses are recorded and taxed on the owner’s personal tax return.” The U.S. Small Business Administration states that “profits and losses can get passed through to your personal income without facing corporate taxes. However, members of an LLC are considered self-employed and must pay self-employment tax contributions towards Medicare and Social Security.”

An LLC is best suited for a simple business where your net profit is the same as or lower than a similar job at another company if you were an employee. If you’re making more money than you would be working for another employer, an S corp may be a better business structure for your company, as it will lower the self-employment tax. An LLC is easier to set up with fewer regulatory requirements compared to other types of corporations. You won’t have to deal with as much paperwork, and you can have unlimited members. LLCs are typically utilized by sole proprietors or partnerships and can be used for companies of any size, such as a doctor’s office or family business partnership. LLCs employ an LLC operating agreement, which allows the owner(s) to set up and operate the business in whatever fashion they choose.

Of course, there are disadvantages. With an LLC, raising capital is more challenging, as you can’t issue shares. It often has to rely on bank loans for a cash injection vs. venture capital that corporations often receive. Also, if a member leaves the company, you must dissolve the LLC.

C Corporation

A C corporation, commonly known as a C corp, is a legal entity most commonly seen in larger companies. It offers limited liability for employees, shareholders, and executives. There are no restrictions on the number or country of origin of shareholders allowed, which is why many publicly traded companies hold this status. It’s generally easier to raise financing in this corporate structure compared to other business structures. It’s best suited for businesses looking to keep profits in the business. In an S corp or LLC, all profits must be paid out and can’t be reinvested in the business. In a C corp, you can keep profits that aren’t paid out within the company, and profits are tax-exempt as long as they are held within the company.

For example, if your business has $100,000 of net profits, in a C corp, if you pay yourself $60,000, the remaining $40,000 can stay within the company. This means you only have to pay taxes on $60,000, and you can keep the $40,000 of tax-exempt earnings within the company. The $40,000 remaining within the company is called retained earnings, and it must be held in a separate account. A buildup of retained earnings can significantly increase a company’s net worth. You can have tax-exempt money in your account to reinvest into your business.

As a C Corp, double taxation will occur if your company has over 100 shareholders, foreign shareholders, offers multiple classes of stock, or if your company is a financial or insurance company. Because of these tax implications, shareholders can’t write off business expenses and losses on their personal tax returns. C corps are also more time-consuming and expensive to start and maintain and have many—and more rigid—requirements and regulations.

S Corporation

An S corporation, commonly known as S corp, was created by Congress in 1958 so that small businesses could get the same tax advantages as corporations. Unlike a C corp or LLC, which are legal entities, an S corp is a tax designation that prevents double taxation, meaning you will not pay taxes twice on the same income source. An S corp generally avoids corporate federal income taxes. Investopedia states that “S corporations can elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. The shareholders of the S corporation would report the flow-through of income and losses on their personal tax returns. As a result, the assessed tax would be calculated based on their individual income tax rates. This pass-through feature helps S corporations to avoid double taxation, meaning the company’s income is taxed at the corporate level and again when dividend income paid to shareholders is taxed on their personal income tax returns.”

An S corp is similar to an LLC in that it protects the owners’ personal assets from corporate liability and allows pass-through taxation, generally through paying dividends. This helps avoid double and personal taxation. To receive an S corp tax designation, you must first register an LLC or C corp in the state where you primarily do business. Once your business is registered, you must send Form 2553 to the IRS indicating that you want the company to be taxed as an S corp.

Another advantage of an S corp over an LLC is that if you’re a small business and your net income is similar to a salary you would earn if you worked a similar job for another employer, you don’t have to pay any self-employment tax. First, we must define the term “reasonable salary.” According to the IRS, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” This means that your salary should be comparable to a salary for the same position at another company, accounting for training and experiences, responsibilities, time and effort devoted to the business, and what comparable businesses pay for similar services, among other things. You can read more about a reasonable salary here.

Let’s say your business earns $100,000 net profit in one year. Net profit is achieved after subtracting all expenses. Without an S corp tax designation, you’ll be subject to 15.3% self-employment tax on the $100,000. This means you’ll pay $15,300 to Uncle Sam. But if your business has an S corp tax designation, you can lower your tax bill by taking a salary. An LLC set up as an S corp would report your salary as a business expense and deduct payroll taxes from it. The remaining profits would be distributed as a dividend, or the distribution of a company’s earnings to its shareholders.

If you want to reduce your self-employment tax, ask yourself: How much would an employer pay me to perform the same job if I were an employee? Suppose that number calculates out to be $60,000. In an S corp tax designation, you can pay yourself a salary of $60,000, and then you would only have to pay self-employment tax on only $40,000 (the profit dividend), which comes out to $6,120—a savings of a whopping $9,180 and more money in your pocket instead of simply handing it over to Uncle Sam.

A few cons: It’s important to note that the S corp tax designation may lower your tax bill, but it does come with more paperwork and rigid restrictions on how these entities can be structured and run. Per Investopedia, “The numerous internal formalities required for S corporations include strict regulations on adopting corporate bylaws, conducting initial and annual shareholders meetings, keeping and retaining company meeting minutes, and extensive regulations related to issuing stock shares.” S corps must have a board of directors to make important corporate decisions and corporate officers to manage the day-to-day operations and decisions.

The IRS has more restrictions on who can own an S corp; it can’t have more than 100 shareholders (or owners), and they must be U.S. citizens, permanent residents, or other specific entities. Lastly, some states don’t allow S corp income to be taxed on the owners’ personal income tax returns—an important item to note and research in your state if you are thinking about setting up an S corp. You also have to set up a payroll and document paying yourself.

Takeaway

Before starting a business, knowing what entity/designation to use is essential. What structure you elect to employ will depend on your company’s size; structure; management, financial, and growth goals; and desired tax implications. According to Investopedia, “In general, the smaller, simpler, and more personally managed the business is, the more appropriate the LLC structure would be for the owner. If your business is larger and more complex, an S corporation structure would likely be more appropriate.”

Because it’s less cumbersome and more cost-effective to set up, an LLC is best suited for a small business or sole proprietorship where you want to protect your personal assets from the company’s debt or other liabilities. LLCs allow owners more management flexibility and latitude (no board of directors or corporate officers are required). If your LLC business generates more money than you would be working for another employer, it’s more advantageous to elect an S corp tax designation. This comes with more paperwork, but the additional paperwork may be worth it since electing an S corp can significantly lower your tax bill. If you intend for your company to raise capital, seek out investors, keep more profits in the business, or eventually become a publicly traded company with common stock and shareholders, a C corp may be the best structure for your business. You can elect to designate your company as an S corp after you set up the C corp to enjoy the tax benefits listed above. However, once you have over 100 shareholders, you can no longer be designated as an S corp.

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References

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Hayes, Adam. (June 28, 2022). What Is a Dividend? Investopedia. https://www.investopedia.com/terms/d/dividend.asp

Internal Revenue Service. (August 2008). Wage Compensation for S Corporation Officers. https://www.irs.gov/pub/irs-news/fs-08-25.pdf

Johnson, Simone. (August 3, 2022). Should You Set Up Your Business as an LLC or S Corporation? Business News Daily. https://www.businessnewsdaily.com/15339-llc-vs-scorporation.html

Kagan, Julia. (July 22, 2022). C Corporation. Investopedia. https://www.investopedia.com/terms/c/c-corporation.asp

Majaski, Christina. (July 21, 2022). LLC vs. S Corporation: What’s the Difference? Investopedia. https://www.investopedia.com/articles/personal-finance/011216/s-corp-vs-llc-which-should-i-choose.asp

Stockton, Blake. (June 19, 2020). LLC vs S-corp vs C-corp: What is the Best for Small Business? Fit Small Business. https://fitsmallbusiness.com/llc-vs-s-corp-vs-c-corp/#:~:text=The%20LLC%20is%20a%20low,keep%20profits%20in%20the%20business.

U.S. Small Business Association. (n.d.) Choose a business structure. https://www.sba.gov/business-guide/launch-your-business/choose-business-structure