The limited liability company (LLC), S corporation (S-corp), and C corporation (C-corp) are all business structures that you may be considering. The LLC is a low-maintenance legal entity that’s best for a simple business. An S corporation is a tax status created so that business owners can save money on taxes. A C corporation is a more complicated legal entity that’s best for businesses looking to keep profits in the business.
We’re going to break down and explain these business structures as clearly as possible with information the typical small business owner needs to know.
Before we get into an in-depth explanation of the LLC vs S-corp vs C-corp, here’s a simple cheat sheet of the three business structures and what they do:
What Exactly Is an S-corp?
We need to start with an explanation of the S-corp because the S-corp is technically not a business structure—it’s a tax status. In 1958, Congress created the S corporation, also called the small business corporation, so that smaller businesses could get similar tax advantages as a corporation, but without the double taxation.
One common misconception online is that S-corp is a business structure—it’s not. Again, it’s a tax status, sometimes called a tax designation.
To receive the S-corp tax status (whose benefits we’ll explain below), you first register as an LLC or C-corp with the state you’re primarily doing business in. Then, once registered, send Form 2553 to the IRS to indicate you’d like to tax the business as an S-corp.
What complicates matters is that online legal services often say they will register your business as an S-corp, but that isn’t what happens. Again, you choose an LLC or C-corp and then designate (also called “elect” in tax-world speak) that business an S-corp for tax purposes.
Tip: The S-corp is a designation at the federal level (IRS), not the state level. If you’re registering your business with the state, such as an LLC or C corporation, don’t be surprised if you don’t see any information about S corporations.
Now, you may be wondering why you would want to elect your LLC or C-corp an S-corp for tax status? It comes down to saving money on taxes.
Why Elect the S-corp Tax Status?
LLC’s and S-Corps both pay the same income taxes on their net profits. The potential tax savings from an S-corp comes from FICA taxes. LLC’s pay FICA tax on all of their net profit, while an S-Corp only pays FICA taxes on the reasonable salary of the shareholder.
LLCs pay FICA tax as a 15.3% self-employment tax on the owner’s tax return. S-corps pay FICA taxes as payroll taxes with 7.65% coming from the shareholder/employee and 7.65% being paid by the S-corp/employer. Regardless, if there is only one owner the entire 15.3% FICA burden is ultimately borne by the owner.
Let’s say your business is an LLC and earns $75,000 in net profit, which is the profit after subtracting expenses. Congrats! However, there is bad news. You’ll have to pay a 15.3% self-employment tax (FICA), which is $11,475. Ouch.
Consider this question: If you were to get paid for the work you’re currently doing in another similar business, how much would they pay you? For this example, let’s say an owner would pay you a salary of $45,000 to do a similar job in a comparable business.
Some would argue that you cannot compare a business owner to another managerial role. But the IRS doesn’t care about that argument. Use your common sense and our guide to determine a reasonable salary.
Back to the example: Let’s take your $45,000 “reasonable” salary and deduct it from the net income of $75,000, which leaves you with a dividend of $30,000. You and the S-corp must each pay 7.65% FICA tax on the salary of $45,000 for a total tax of $6,885. The great thing about an S-corp is that nobody has to pay FICA tax on the $30,000 dividend – saving you (in this example), $4,590 in FICA taxes. That’s a lot of money just for changing your tax status to an S-corp!
Which Business Structure Is Right for You?
When to Choose an LLC Rather Than an S-corp
If an S-corp helps a business save money on taxes, why would anyone choose an LLC? Well, if you’re making as much or less than what you could make doing a similar role at another company, you can’t save money on taxes because your reasonable salary would consume the entire profit.
For example, if you’re earning $40,000 net profit, and $40,000 is a “reasonable” salary for the job, you could just stay an LLC without electing S-corp tax status.
One downside of designating your business as an S corporation, compared to only an LLC, is that it does require additional paperwork. Your taxes are a little more complicated, as well. As a single-member LLC you’ll include your business activity directly in your individual return on Schedule C. If you elect S-corp status, you’ll need to report your business activity on a separate return filed on Form 1120S—you may need a tax professional’s assistance.
Additionally, you will need to set up payroll with an S-corp. You need to document paying yourself a salary and also take out FICA taxes every month and file payroll tax returns.
For simplicity’s sake, many business owners, such as freelancers, choose the LLC to avoid this additional work.
Benefits of an LLC
- Personal asset protection
- Easy to form
- Less paperwork
- Unlimited members
Disadvantages of an LLC
- All net profits are taxed
- Challenge to raise outside capital
- LLC dissolves if a member leaves
LLC vs LLP
Something you may need to know is the difference between a limited liability company and a limited liability partnership (LLP). The LLP is typically for professional businesses with multiple partners that carry liability (aka can get sued), such as doctors, lawyers, and accountants.
If you’re a doctor and open a clinic with two other docs, you wouldn’t want your share of the business to be at risk because of malpractice by another doctor. An LLP separates risk among each partner—the error of one doesn’t affect the finances of the other.
Why Choose a C-corp?
With tax advantages of the S-corp, why would anyone choose to register their business as a C-corp—especially with its double taxation?
One of the main reasons a business creates a C-corp is again, to save money on taxes—but through a different avenue. With an LLC or S-corp, the entire net income is taxed to the owner regardless of any cash payments made. With a C-corp, profits not paid out as salary are taxed to the corporation at a flat income tax rate of 21% which is much lower than the top individual rate of 37%.
As a simple example, if your business earns $100,000 in net profit, you could pay yourself a $75,000 salary. You would pay individual tax on the $75,000 salary, but the $25,000 profit after salary would be taxed to the corporation at only 21%.
The tax problem with a C-corp occurs if you want to pay yourself the $25,000 in addition to your salary. The $25,000 will be taxed to you at the dividend tax rate of 20%, plus still be subject to the C-corp rate of 21% – for a total tax of 41%. This is why you’ll only want to be a C-corp if you plan on retaining some of the earnings in the corporation.
The more common reason for a business to be a C-corp is they are not legally allowed to be an S-corp. Here are when a company is required to be a C-corp:
- Over 100 shareholders
- Foreign shareholder
- Partnership or another corporation as a shareholder
- Multiple classes of stock
- Certain institutions (insurance and financial companies)
Benefits of a C-corp
- Limited liability
- Keep profits in business without being taxed
- The business entity will exist without original owners
- Investor friendly
- Unlimited shareholders
Disadvantages of a C-corp
- Double taxation (at the corporate and individual level)
- Yearly board of directors meeting
- Possibly more expensive with assistance from CPA
How to Register as a Legal Entity and S-corp
DIY: You can register any of the legal business entities through your state’s official business registration website. The fee to register a business can be anywhere from $40 in Kentucky to $500 in Massachusetts.
Online legal service: If you find your state’s registration website difficult to navigate, you can use an online legal service to register your business. IncFile will gather and submit your business registration docs to your state for free, plus state fees. They are the most affordable business registration service available. You can visit IncFile to learn more.
Online legal advice: If you have a legal question, and don’t want to pay the high fee of a local business attorney, consider using a legal service such as Rocket Lawyer. With Rocket lawyer, you can ask unlimited questions for $39.99 per month. Visit Rocket Lawyer for more information.
Local business attorney: If you’re forming a complicated business, such as an investor-ready C corporation, you likely want to hire a local business attorney. It’s also a good idea to build a relationship with a local attorney so you can use them to resolve any legal issues quickly.
Alternatives to the LLC, C-corp, and S-corp
You may read through this guide, and determine that an LLC and C-corp are not the right business structures for your business. Maybe you live in Massachusetts, have a small side-business (that’s very unlikely to be sued), and don’t want to pay the $500 business registration fee. That’s a lot of money.
Your other options are a sole proprietorship, which is for one owner, or a partnership, which is for multiple owners. Both business structures are free, but you may need to purchase a fictitious name (also called doing-business-as) through the state.
Sole Proprietorship
While we don’t generally recommend the sole proprietorship, I wanted to discuss it briefly, so you understand what it is and why it’s a legal structure.
If you don’t register your business in the state it’s doing business in; it’s by default a sole proprietorship. Business owners choose to stay a sole proprietorship if they have a low-liability business (unlikely to be sued), and to avoid the fee to register the business.
The main downside of a sole proprietorship is that if a customer were to ever sue the business, your personal assets are at risk. What does that mean exactly? If a judge rules your business at fault, then the judge could order the liquidation of personal assets or garnish wages to pay damages.
Registering an LLC or corporation is an important legal step because it keeps responsibility to pay any damage from a lawsuit within the business.
If you are keeping your business a sole proprietorship, you may need a doing-business-as (DBA) or also called a fictitious name. If you’re operating under any business name other than your legal name, you will need to register that business as a DBA with the state.
Partnership
A partnership is similar to a sole proprietorship, except that it involves several owners. It is the default business structure for two or more owners that don’t register as an LLC or C-corp. Similar to the sole proprietorship, if a customer or vendor were to sue the business, all partners’ personal finances are at risk.
If you are forming a partnership, we highly recommend creating a partnership agreement. This agreement ensures both you and your partner understand what would happen to the business if a difficult situation arises such as an inability to perform or significant time away from the business.
Frequently Asked Questions
Is an LLC an S or C corporation?
An LLC can be either an S-corp or a C-corp. By default, an LLC is a sole proprietorship if one owner or a partnership if two or more owners. However, an LLC can elect to be taxed as either S-corp or C-corp if they prefer.
Can you be an S-corp and an LLC?
Yes, because an LLC is a type of legal entity whereas an S-corp is a tax treatment. After forming an LLC in the state you’re conducting most of your business, you may elect to have your LLC be treated as an S-corp by filing Form 2553 with the IRS.
Bottom Line
Most owners starting a small business will choose to be an LLC. If a biz owner believes electing S-corp tax status will save money on taxes, they will make that designation.
If a business is earning a lot of profit and the owner would like to keep a portion of profit in the business, or they want to raise funds from an investor, they may want to consider a C-corp.
If your business’s needs are somewhat complicated, seek business legal entity advice from a professional, such as a business attorney or CPA (certified public accountant).
