C Corp, S Corp Or LLC: How Your Entity Shapes What You Personally Pay
Entity choice decides whether profit is taxed once or twice, whether you owe self-employment tax, and which investors and exits remain open to you.
Founders usually pick an entity in an afternoon, often on the advice of whoever helped them file. That choice then decides how profit is taxed, how you get paid, who can invest and what tax treatment is available at an exit. Changing it later is possible but rarely free.
The entity's legal form and its tax classification are related but not identical. An LLC can be taxed as a sole proprietorship, a partnership, an S corporation or a C corporation. What follows is about tax classification, because that is what drives your personal bill.
C corporation: two layers, more flexibility
A C corporation pays federal corporate income tax on its profit. If it then pays dividends, shareholders pay tax on them again. Founders who work in the business are employees and are paid wages, which are deductible to the company.
Double taxation sounds like a reason to avoid the C corp, and for a profitable business that distributes most of its earnings, it often is. But for a company planning to reinvest everything and raise outside capital, the C corp is the standard. Venture funds generally invest in C corporations, partly because their own investors include tax-exempt and foreign entities that pass-through income would create problems for.
A C corporation is also the only entity whose stock can qualify for the Section 1202 qualified small business stock exclusion, which can eliminate federal tax on some or all of a large gain at exit. For a founder aiming for a venture-scale outcome, that can outweigh the cost of two tax layers.
S corporation: one layer, strict rules
An S corporation is a corporation that has elected pass-through treatment. Profit is taxed on the owners' returns whether or not it is distributed, and there is generally no entity-level federal income tax. Owners who work in the business must be paid reasonable wages, and further profit can come out as distributions not subject to payroll taxes.
The constraints are tight. An S corporation is limited in the number of shareholders, can have only one class of stock, and can generally be owned only by US individuals and certain trusts and estates, not by venture funds or other corporations. Preferred stock with liquidation preferences, the standard venture instrument, does not fit a single class of stock. Taking institutional money usually means converting.
LLC taxed as a partnership: flexible but noisy
A multi-member LLC taxed as a partnership passes profit through to its members, who are taxed on their share whether or not it is distributed. The operating agreement can allocate profit and loss in flexible ways, which suits real estate, services firms and joint ventures.
Active members generally owe self-employment tax on their share of earnings, and there is no payroll to withhold for them, so quarterly estimates are the norm. Every member receives a K-1, which can arrive late and delay personal returns. Pass-through owners may also be eligible for the qualified business income deduction, subject to its own limits and exclusions.
Converting later, and the state layer
Many startups begin as LLCs for simplicity and convert to C corporations before raising venture money. It can be done, but the conversion has tax consequences, and for QSBS purposes the holding period and basis generally start at conversion rather than at the original formation.
Moving from an S corporation to a C corporation is usually simpler mechanically but can have consequences for previously taxed earnings and timing. Moving in the other direction, from C to S, can bring built-in gains rules into play on later sales.
States do not all follow federal classification in the same way. Some impose entity-level taxes on pass-throughs, franchise taxes on corporations or minimum annual fees, and many have elective pass-through entity taxes that interact with federal deductions. Where you form the entity and where you operate can both matter, and a structure that looks efficient federally can look different once state costs are added.
What to ask before choosing or changing
Ask three questions. Will you raise from institutional investors, and when? Do you expect to distribute profit regularly or reinvest it? What kind of exit do you expect, and would QSBS matter?
If the answers point to venture funding and a large exit, the C corporation is usually the default. If they point to a profitable business paying its owners, a pass-through is often more efficient. Either way, run the numbers with an accountant using your actual expected profit, and review the decision whenever the plan changes.
This is general information, not tax advice. Rates and thresholds change; confirm current figures with the agencies linked below or with your accountant.
