LLC vs. corporation taxes: What small business owners should know

Tax status doesn’t change liability protection

One of the main reasons small business owners choose to form an LLC or corporation is to limit their personal liability. Both LLCs and corporations are legal entities that exist separately from their owners, regardless of how those entities are taxed. (LLC owners are called members, while the owners of a corporation are referred to as shareholders.)

This separation matters because it helps shield personal assets (such as a home, car, or personal savings) from business debts and lawsuits. If the business is sued or can't pay its debts, creditors generally cannot go after the owner's personal property to satisfy them.

State corporation and LLC laws make this explicit. Corporations and LLCs are responsible for their own debts, and owners aren't personally liable simply because they hold an ownership stake. This means the choice between an LLC and a corporation isn't about which one offers liability protection, since both do.

Tax classification doesn't change what the entity legally is

Some small business owners misunderstand the relationship between tax status and entity status. The federal Internal Revenue Code (IRC) does not have a chapter for corporations and a separate chapter for LLCs. In fact, the IRC doesn't even mention LLCs.

By default, an LLC with one member is taxed like a sole proprietorship, while an LLC with more than one member is taxed like a partnership. An LLC can also elect to be taxed as a corporation. Regardless of how the members choose to have the LLC taxed, the LLC is still an LLC.

The same logic applies on the corporate side. The IRC recognizes two corporate tax classifications, C corporation and S corporation (more on that later). But that's strictly an income tax distinction. Under state corporation law, and for any purpose other than income tax, a corporation is just a corporation. Whether it's taxed as a C corp or S corp doesn't change that.

How corporations are taxed

By default, all corporations are taxed under Subchapter C of the Internal Revenue Code. These are called C corporations. “By default” means that if the shareholders don’t take any action, this is how their corporation will be taxed.

However, there is another option available to corporations. If all the shareholders agree and the corporation qualifies, the corporation can be taxed under Subchapter S of the IRC. These are called S corporations.

How are C corps taxed?

A C corporation is a separate taxpaying entity. It must file a separate corporate tax return, Form 1120, and pay its own taxes.

A C corporation calculates its taxable income before deducting or paying any dividends to shareholders, so those dividends are taxed at the corporate level first. When the corporation later distributes earnings to shareholders as dividends, that income is taxed again, this time at the individual level. In effect, the same earnings are taxed twice.

This double taxation is considered the main drawback of a C corporation tax status, particularly for owners who want to distribute a large share of the profits to themselves as dividends.

How retained earnings affect C corp tax liability

In a C corporation, owners are taxed only on the earnings they receive as dividends, not on earnings the corporation retains. This is generally considered an advantage of C corporation taxation. (In a pass-through entity, owners are taxed on their share of the entity's earnings whether the earnings are distributed or retained.)

However, if a C corporation retains earnings beyond what the IRS considers reasonable for the needs of the business, it may be subject to the accumulated earnings tax. This is a penalty tax aimed at corporations that build up earnings and profits, instead of distributing them, in order to help shareholders avoid paying income tax.

The IRC also imposes an additional tax on certain closely held corporations known as personal holding companies. These are corporations that meet specific tests related to stock ownership and income. A personal holding company must pay extra tax on its undistributed personal holding company income, which includes dividends, interest, and certain royalties.

The rules surrounding the accumulated earnings tax and personal holding company tax are complex. Small business owners who think either could apply to them should consult a tax adviser.

How are S corps taxed?

As noted, a corporation is by default a separate taxpaying entity. However, a corporation may be able to elect to be taxed as a pass-through entity instead. This election, commonly referred to as the "subchapter S election", is made by filing Form 2553 with the IRS.

Once the election is in place, the S corporation still has to file a tax return (Form 1120S), but the corporation itself doesn’t pay taxes. Instead, the profits, losses, and other tax items pass through to the owners, who report them on their own Schedule E and Form 1040.

Eligibility to elect S corporation status

Not every corporation can elect to be taxed as an S corporation. To be eligible, a corporation must

• Have 100 or fewer shareholders (members of the same family can be counted as a single shareholder)
• Have shareholders who are 1) individuals* and 2) United States citizens or resident aliens
• Have only one class of stock

Different classes of voting rights are allowed, but one class of stock cannot receive a dividend (or any other financial advantage) that another class doesn’t receive.

*Note: Certain trusts and estates are also allowed.

Timing of S corporation election matters

If you do not elect S corporation status when you form your corporation, you may have to deal with the built-in gains from the period it was taxed as a C corporation. A tax adviser can help you address any issues this may create.

State taxation of S corporations can vary

If you form a corporation and then elect S corporation status for federal tax purposes, don't assume your state will automatically recognize that election.

Most states will follow the federal election in assessing state taxes, but some do not. Even states that allow S corporation taxation may require a separate state-level election before recognizing it.

A few states also impose a special tax on business income, regardless of entity type. It's worth checking whether this applies in the state where you will form your entity, as well as any state where it does business, so you have a complete picture of your tax liability.

How are LLCs taxed?

By default, the IRS treats a single-member LLC as a “disregarded entity”. This means the IRS will treat the LLC as if it was a sole proprietorship. It's still an LLC, though, not a sole proprietorship. It's simply being taxed like one.

An LLC with more than one member is taxed by default as if it were a partnership, under the rules in Subchapter K of the IRC. Here, too, the LLC remains an LLC. It’s only being taxed like a partnership.

Under these default classifications, the LLC itself is not a taxpaying entity. The owners make tax payments by reporting their share of the LLC’s profit and loss (whether or not it is actually distributed) on their personal income tax returns.

Most single-member LLC owners must report income and business expenses on Form 1040 Schedule C.

Members of a multiple-member LLC receive a Schedule K-1 from the LLC, which they use to report their share of income on Schedule E and any other forms the K-1 indicates, all filed with Form 1040. A multi-member LLC also must file a partnership information return, Form 1065, showing how income came in and was distributed to members. No federal tax is imposed at the entity level.

LLCs can choose to be taxed as a C corp or S corp

LLC owners don't have to take any action if they are satisfied with the default classification.

However, any LLC can elect to be taxed as a C corporation by filing Form 8832, Entity Classification Election. If the LLC meets the S corporation eligibility requirements described above, it can then elect to be taxed as an S corporation instead. Regardless of which classification an LLC elects, it remains an LLC.

How the LLC will be taxed should be noted in the LLC operating agreement.

Most states follow federal taxation rules for LLCs

Nearly all states follow the lead of the IRS in assessing state income tax on LLCs. In these states, an LLC is automatically treated as a disregarded entity or pass-through entity for state income tax purposes, and no state-level corporate tax applies. If the LLC makes a federal entity classification election, most states will honor it as well.

Common state business taxes

Whether you operate a statutory business entity like an LLC or corporation, or operate a sole proprietorship or general partnership, you are subject to state and local tax laws. While some obligations (like franchise taxes) are levied strictly on statutory business entities, many other state taxes apply to all businesses regardless of their legal structure.

Because every state sets its own tax rates and collection rules, your specific obligations will depend on where your business operates. Common state business taxes include:

• Franchise tax. A franchise tax may be imposed on corporations, LLCs, and other business types formed through a state filing, simply for the privilege of being incorporated or organized in that state. States can also impose franchise tax on businesses that are registered to transact business there (a process called foreign qualification), even if the business wasn't originally formed in that state.
• Sales tax. There are different types of sales taxes. Some are paid by the seller while others are paid by the buyer.
• Use tax. While sales tax applies to retail sales within a state, use tax applies to the storage or other use of tangible personal property or taxable services in a state.
• Property tax. Most property taxes fund local governments rather than the state, but they’re still a tax obligation your business needs to plan for. Owning real estate isn't a requirement either. Many state and local governments also tax personal property like furniture, equipment, and leasehold improvements.
• Income tax. Income tax falls into two categories: corporate income tax and individual income tax. Pass-through entities, such as LLCs and S corps, generally pass business income to their owners, who then pay individual income tax on it. Some states also allow eligible pass-through entities to elect to pay tax at the entity level instead, so it's worth checking your state's specific rules.

Factoring in self-employment tax in your entity selection

Self-employment tax is one tax issue to consider when deciding between an LLC and a corporation, and when deciding how that entity should be classified for tax purposes.

The members of an LLC taxed under its default classification who actively work for the business are considered owners, not employees. They must pay self-employment taxes (for Social Security and Medicare) on the income they receive from the LLC whether that income comes as a guaranteed payment or as a share of the profits.

In a corporation (whether it’s a C corp or S corp), those who work for the corporation are treated as employees, even if they are also shareholders. As employees, they pay Social Security and Medicare taxes only on their salary, not on any profit distributions they receive.

This difference leads some LLC owners to elect corporate tax status, often as an S corporation if the LLC qualifies, since it can reduce their self-employment tax liability.

One caveat: S corp shareholder-employees, including LLC members who elect S corp status, must still pay themselves a reasonable salary subject to payroll tax. Only profit distributions beyond that salary escape self-employment tax.

How tax status affects fringe benefits and retirement plans

A fringe benefit is compensation paid to employees for performing services beyond that of the regular salary. How these benefits are taxed, and whether they're deductible, depends on the entity's tax classification.

In a C corporation, the employees can exclude the value of the benefits from their personal income. This is true even if they are also owners.

S corporations, and certain LLCs, are subject to additional rules around fringe benefits for owners who also work in the business. Depending on ownership percentage, some benefits that would otherwise be tax-free may need to be included in the owner's personal income. Because these rules are detailed and vary by situation, it's worth reviewing your specific setup with a tax adviser before assuming a benefit is tax-free.

Retirement plan and stock option rules also differ depending on whether the entity is taxed as a C corporation or as a pass-through entity.

Finding the right tax structure for your LLC or corporation

By default, a corporation is a separate tax entity. It pays federal income tax, and in many states, state income tax as well, and shareholders pay tax on any dividends they receive. This structure offers some advantages, including greater deductibility of fringe benefits and retirement plan contributions, and the fact that shareholders aren't taxed on profits the corporation retains. Its main drawback is double taxation on profits distributed to shareholders.

A qualifying corporation can instead elect S corporation status and be taxed as a pass-through entity. Rather than the corporation paying income tax, its income, losses, and other tax items pass through to shareholders, who report their share on their personal returns. This avoids double taxation and can reduce self-employment tax compared to other pass-through entities, though S corporation fringe benefit rules are generally less favorable than those available to C corporations.

An LLC can be taxed in one of four ways.

• A single-member LLC, by default, is taxed as a disregarded entity, meaning the business’s profits and losses are reported as the owner’s profits and losses. This is the simplest of tax schemes since there is no separate tax filing beyond the owner's Form 1040.
• An LLC with more than one member is taxed by default as a partnership. Profits and losses pass through to the members, who report their share on their personal returns.
• LLC members can elect to have the LLC taxed under C corporation rules.
• If the LLC qualifies, members can instead elect S corporation tax treatment.

Disregarded entities and pass-through entities share a key advantage: profits are taxed only once, at the owner level, rather than at both the entity and owner level.

There is no single right answer for every small business. The best tax classification depends on factors like how much profit you plan to retain in the business, how you intend to pay yourself, what benefits you want to offer, and your tolerance for compliance complexity. Because tax law is detailed and subject to change, working with a tax professional is the best way to make sure your choice fits your specific situation.