Those who form a business must balance present savings against future scalability when choosing their business and tax structure. However, if you can’t articulate the difference between an LLC versus S Corp versus C Corp, you could be positioning yourself for challenges down the road. Learn the difference between an LLC, an S corp and a C corp and how choosing each designation can impact your taxes, fundraising and more.
LLC vs. S Corp vs. C Corp: Taxation & Electing Your LLC as a Corporation
A Limited Liability Company (LLC) is generally easy to form and primarily serves to shield the personal assets of its owners, known as members, from business debts and legal troubles. The IRS automatically recognizes businesses not structured with an S corporation or C corporation designation as disregarded entities or partnerships, depending on the number of owners.
In an LLC operating as a disregarded entity or partnership, profits and losses are passed directly to the owners who report them on their tax returns. Owners pay self-employment taxes (social security and Medicare) on their share of the net income.
LLCs are automatically taxed as a disregarded entity or partnership unless they file otherwise. LLC owners can opt for tax classification under an S corporation or C corporation without losing their legal LLC structure in order to reduce self-employment tax and maximize savings. However, this is only possible if the LLC is considered eligible, and the LLC will need to comply with that corporation’s income tax rules.
Why Would an LLC Elect to Be Taxed as a Corporation?
Some LLCs can receive substantial tax advantages be electing to be taxed as an S corp or C corp. What does this mean?
An S corporation (S corp) designation is a popular tax structure election for profitable, privately held small and midsize companies. However, the number and type of shareholders an S corp can have are limited to just 100. Classifying your LLC as an S Corp allows it to maintain pass-through taxation. However, any owner working in the business must receive a reasonable salary. That salary is subject to FICA taxes, but owners can distribute profits beyond the salary to shareholders as tax-free dividends.
An LLC will file Form 2553 to be taxed as an S corp. If eligible, they can benefit from:
- Elimination of costly self-employment taxes
- Savings on payroll taxes
- Tax savings without state law regulations for corporations (e.g., required board of directors)
A C corporation (C corp) is considered a separate legal entity from its owners. Due to the double taxation of C Corps, the company pays corporate taxes on its profits, and shareholders or owners are taxed separately. Establishing a C corp requires careful documentation and adherence to regulatory requirements. so this classification is usually best suited to maturing startups that are ready to ramp up serious growth and fundraising efforts.
An LLC will file Form 8832 to be taxed as an C corp. If eligible, they can benefit from:
- A flat corporate tax rate that may be lower than current tax obligations
- Fewer tax deduction limitations than partnerships or S Corps (e.g., retirement, life insurance, etc.)
- Easier access to certain PE and VC investors
Remember that electing to be taxed as a corporation greatly increases the complexity of your tax filing. Corporation status can also come with many limitations, especially around specific allocations. It’s important to work with a tax specialist who can help you navigate these tax classifications, prepare the right documentation and take advantage of potential savings.
LLC vs. S Corp vs. C Corp: Ownership & Operational Differences
An LLC and a corporation are separate entities, which means that while you can file as a corporation for tax purposes, you must enter the legal process of becoming a corporation in order to operate as one. There are key differences in ownership and management of an LLC versus a C corp or S corp.
Structuring an LLC as a disregarded entity or partnership versus a S corp or C corp allows its members to maintain excellent flexibility in management and ownership. Members can choose to share the work of managing the LLC or designate certain members or third parties to facilitate day-to-day operations.
S corps and C corps adhere to a traditional corporate structure, where a board of directors elected by shareholders guides major policies and officers handle daily operations. However, while a C corp’s owners can include an unlimited number of individuals, other corporations and foreign entities, an S Corp can only have 100 shareholders—all of whom must be individuals and either U.S. citizens or permanent residents.
Fundraising Limitations and Options
C corps and S corps can both raise money by selling equity in the company. C corps often raise money by going public, but an S Corp will need to find individual investors due to the 100-person shareholder cap. An LLC structured as a disregarded entity or partnership can raise money from member contributions, loans or private investors.
Can You Have Hybrid Business Combinations?
Hybrid business structures can improve flexibility and enhance growth potential. For example, a business owner can be an entity, such as a C corp, but hold an LLC subsidiary, allowing you to expand into new business areas without the reporting requirements of a C corp or additional expenses tied to the C corp. However, consulting experts is essential to ensure legal and regulatory compliance regarding S corp versus C corp hybrid models.
Why Would an LLC Change Its Structure?
Changing a company’s structure should always be a strategic decision timed to align with a company’s developmental stage and long-term goals.
LLCs may change their structure to a corporation to:
- Reduce self-employment taxes by splitting income between wages and dividends.
- Facilitate raising investment capital by selling shares and raising funds from VC investors.
- Improve business valuations, trading based on future profit potential, which can increase value. LLCs trade on asset values.
- Support additional tax-advantaged fringe benefits.
- Easily transfer ownership transferability.
- Attract top talent due to greater ease with equity-based employee incentive programs.
Choosing the Right Structure for Your Business
Here’s a recap of key considerations to figure out the ideal structure for your venture:
- Alignment with business vision
- Immediate financial needs versus long-term growth goals
- Tax implications of an LLC versus S corp versus C corp
- Fundraising ability
- Ownership and management flexibility
Need more guidance for your specific circumstances? Schedule a free consultation to learn how Paro tax experts can support your tax planning and answer your questions about the right business structure and tax classification for your goals.