S-Corp vs LLC vs C-Corp: Entity Structure Guide for Business Owners

Entity structure is one of the highest-impact planning decisions a business owner makes — yet most owners inherit their structure by default rather than by design. The difference between the wrong and right entity can easily exceed $20,000 a year in avoidable taxes.

The default starting point: sole prop / Schedule C

When you first start a business, you're automatically a sole proprietor. Your income flows to Schedule C on your personal return. There's no separate business entity, no registration required, and no complexity. That simplicity has a cost: you owe self-employment (SE) tax on 100% of net profit — 15.3% on the first $184,500 (2026 Social Security wage base),¹ then 2.9% (Medicare only) above that, plus an additional 0.9% Medicare surcharge on income over $200,000 (single).²

For a business netting $300,000, the SE tax alone is roughly $42,400 per year.

LLC: a legal wrapper, not a tax election

An LLC (limited liability company) provides personal liability protection — your home and personal savings are shielded from business creditors and lawsuits. It does not by itself change how you're taxed.

• Single-member LLC: treated as a disregarded entity for federal tax. You file Schedule C, pay the same SE tax as a sole prop.
• Multi-member LLC: taxed as a partnership by default. Each partner pays SE tax on their share of active income.

The tax savings come from electing a different tax treatment — most commonly the S-corp election — while keeping the LLC as the legal entity. Many business owners hold their S-corp election inside an LLC operating agreement.

S-corp: the FICA savings play

An S-corp is a pass-through entity (income flows to your personal return), but it changes how you take income from the business. As an S-corp owner, you wear two hats:

1. Employee: You receive a W-2 salary. FICA taxes (15.3%) apply to the salary.
2. Shareholder: Remaining profits are distributed to you. Distributions are not subject to FICA.

The reasonable compensation requirement

The IRS requires that S-corp owner-employees pay themselves a "reasonable" salary — comparable to what you'd pay an arm's-length employee to do your work. You can't set a $20,000 salary on $500,000 of business income and pocket $480,000 as distributions. The IRS routinely recharacterizes distributions as wages in audits, triggering back FICA, penalties, and interest.

Factors the IRS considers: your industry, duties performed, comparable wages in your market, the company's revenue, and published compensation surveys. A common safe-harbor approach: salary equal to what the business would pay a qualified replacement.

See our S-corp vs LLC tax calculator to model your specific savings based on salary and income level.

S-corp + Section 199A QBI deduction interaction

Above the income threshold ($201,775 single / $403,500 MFJ in 2026),³ the § 199A qualified business income deduction gets limited by W-2 wages. An S-corp creates W-2 wages — which can preserve the deduction for high-income owners who would otherwise lose it.

S-corp limitations

• Maximum 100 shareholders
• All shareholders must be U.S. citizens or permanent residents (no foreign owners)
• Only one class of stock (no preferred shares)
• No corporate or partnership shareholders
• Ineligible for QSBS (§ 1202) — that requires a C-corp

The first three are rarely an issue for privately-held small businesses. The QSBS restriction is significant if you plan to seek venture or private equity investment, or if you anticipate a large business sale.

C-corp: when it's the right answer

C-corps pay a flat 21% federal corporate tax rate⁴ on earnings retained inside the business. You also pay individual tax when those earnings are distributed as dividends — so income that flows out to owners faces double taxation (corporate rate + dividend rate). That double tax makes C-corps inefficient for businesses that distribute most of their profits to owners.

But C-corps make sense in two specific situations:

1. QSBS: the $15M federal tax exclusion

Section 1202 of the IRC allows shareholders to exclude up to $15M of gain from the sale of qualified small business stock (QSBS) from federal income tax entirely — that's a potential $5.55M of avoided tax at the 37% rate.⁵ The One Big Beautiful Bill Act (OBBBA, July 2025) raised the exclusion from $10M to $15M permanently and tiered the exclusion by holding period:

• 3-year hold: 50% exclusion
• 4-year hold: 75% exclusion
• 5-year hold: 100% exclusion

Requirements: stock must be in a domestic C-corp (not S-corp, not LLC), original issuance, gross assets at time of issuance ≤ $75M, active trade or business in a qualified industry (most product/technology/manufacturing companies qualify; professional services generally don't). The business owner must be the original purchaser — secondary-market shares don't qualify.

If you're building a software company, manufacturing business, or other product business with a realistic 5+ year exit horizon, structuring as a C-corp from the start to preserve QSBS eligibility can be worth millions.

2. Venture and private equity investment

Institutional investors — venture capital firms, private equity funds, and angel investors using convertible notes — almost universally require a Delaware C-corp with preferred stock. S-corps can't issue preferred shares and have the 100-shareholder limit. If outside investment is likely in your plans, C-corp is the only realistic option.

3. Earnings retention at 21%

If your business generates substantial profits that you want to reinvest rather than distribute, retaining them inside a C-corp at 21% is better than taking them as pass-through income taxed at 37%. This strategy works best for capital-intensive businesses building toward a sale — the retained earnings build asset value for the eventual transaction.

C-corp drawbacks

• Double taxation on distributions. Dividends are taxed at the corporate level (21%) then again at the shareholder level (qualified dividend rate up to 23.8% including NIIT).
• No § 199A QBI deduction. C-corp income is not eligible for the 20% pass-through deduction. Pass-through entities (S-corps, LLCs, sole props) get this; C-corps don't.
• More complex ongoing compliance. Separate federal and state returns, potential for accumulated earnings tax if you retain too much without business justification.

Entity structure comparison

How to decide

Most profitable small business owners follow this logic:

1. Under ~$60K net income: Stay as sole prop or single-member LLC. The SE tax cost is real but the S-corp admin overhead isn't worth it yet.
2. $60K–$500K net income, no outside investment planned: S-corp election is almost always the right answer. FICA savings compound every year and the § 199A interaction adds a second benefit above the income threshold.
3. Planning to raise VC / PE, or have realistic $15M+ exit on a product business: C-corp from the start to preserve QSBS eligibility. Lock in your stock issuance date — the 5-year holding period clock starts then.
4. Already an S-corp but growing toward a sale: An "F-reorg" (S-corp → C-corp via §368(a)(1)(F) reorganization) can convert to C-corp and restart the QSBS clock while keeping operational history. Requires attorney + tax counsel.

When to change entity structure

Entity changes are not trivial — they involve legal filings, new EIN applications, and potential tax consequences. But they're also not as scary as they seem:

• Sole prop → LLC: File with your state, no federal tax change. Do this for liability protection as soon as the business has meaningful assets or revenue.
• LLC → S-corp election: File Form 2553 with the IRS. Tax consequences are generally minimal. File by March 15 to be effective the current tax year; file by December 31 for next year.
• S-corp → C-corp: Revoke the S election (Form 1120-S instructions). Often done in an F-reorg when pursuing QSBS. Consult a tax attorney — there are restrictions on re-electing S status.

The right time to structure is at the start — but it's not the only time. A fee-only advisor who works with business owners will model the tax impact before and after any transition.

Sources

1. SSA Contribution and Benefit Base — 2026 Social Security Wage Base: $184,500. Social Security Administration, 2026 Cost-of-Living Adjustments.
2. IRS Topic No. 751 — Social Security and Medicare Withholding Rates. Additional 0.9% Medicare surtax applies to wages and self-employment income above $200,000 (single) / $250,000 (MFJ). No wage base limit for Medicare.
3. IRS Rev. Proc. 2025-32 — 2026 § 199A phaseout threshold: $201,775 (single), $403,500 (MFJ). OBBBA (July 2025) expanded phaseout range to $75,000/$150,000 and made § 199A permanent. See also Section 199A QBI Calculator.
4. Tax Foundation — C Corporation Tax Rate. Federal corporate income tax rate is 21% (TCJA § 11001, permanent). State corporate taxes additional; rates vary by state.
5. IRC § 1202 — Partial exclusion for gain from certain small business stock, via LII/Cornell Law School. OBBBA (July 2025) raised exclusion cap from $10M to $15M, with tiered holding periods: 50% exclusion at 3 years, 75% at 4 years, 100% at 5 years. Gross assets at issuance must not exceed $75M. C-corp requirement and qualified trade or business test unchanged.

Tax rates and thresholds cited are for federal tax year 2026. State taxes vary. SE tax calculation uses the standard simplified method (net SE income × 92.35% as the taxable base). QSBS rules reflect OBBBA as enacted July 4, 2025. Values current as of April 2026.