When you start a business, choosing a legal structure often feels like a box you just need to check.
You want to get up and running quickly, so you pick up an LLC or corporation, file the paperwork, and move on.
For many business owners, this decision is made without fully understanding how much it affects taxes, cash flow, and long-term growth.
What you may not realize is that your business entity choice can cost you or save you thousands of dollars each year.
The structure you choose determines how you are taxed, how profits are distributed, and how much flexibility you have as your business grows. Once revenue starts increasing, the wrong entity can quietly drain cash through unnecessary taxes and missed planning opportunities.
According to the IRS, millions of businesses in the U.S. are structured as pass-through entities, such as LLCs and S Corporations, because of how income flows directly to the owner’s tax return.
In fact, the IRS reports that more than 95 percent of U.S. businesses are pass-through entities, which highlights how common these decisions are and how important it is to get them right.
What many business owners are not factoring in is that major parts of today’s tax rules are temporary. Several key provisions affecting LLCs and S Corporations are scheduled to expire at the end of 2025, which could significantly change the tax efficiency of your entity choice if Congress does not act.
This guide is designed to help you understand how LLCs, S Corporations, and C Corporations work from a tax perspective.
You will learn how each structure is taxed, when each one makes sense, and how to think about tax efficiency in the context of your business goals.
Let’s jump in!
What is a Business Entity in the U.S.?
Before you can choose between an LLC, S Corporation, or C Corporation, it helps to understand what a business entity is and why it matters.
Your business entity is not just paperwork. It defines how your business is recognized legally and how it is taxed by the IRS.
A business entity is the legal structure your business operates under. It separates your business activities from you as an individual and determines how income, expenses, and liabilities are handled.
When you form an entity, you create a legal identity for your business that can earn income, pay taxes, and enter into contracts.
One of the biggest reasons business owners form entities is liability protection. A properly structured and maintained entity helps protect your personal assets if the business faces lawsuits or debt.
According to the U.S. Small Business Administration, choosing the right legal structure can help limit personal liability and clarify how your business is taxed.
Your entity also affects how cleanly you separate personal and business finances. This separation is critical not only for legal protection but also for accurate financial reporting and tax compliance.
Why the IRS Cares About Your Entity Type
The IRS cares about your entity type because it determines how income is reported and taxed.
Some entities pay taxes at the business level, while others pass income directly to the owner’s personal tax return.
This difference can significantly impact how much tax you owe each year.
For example, pass-through entities like LLCs and S Corporations report income on the owner’s individual return, while C Corporations file their own corporate tax returns.
In addition, your entity type determines whether you qualify for certain deductions that are currently temporary under federal law, including the 20 percent Qualified Business Income (QBI) deduction.
The IRS collects data showing that pass-through businesses generate the majority of business income in the U.S., which is why entity classification receives so much scrutiny.
Your entity type also determines which tax forms you file, how payroll taxes apply, and what deductions or credits you may qualify for.
Choosing the wrong entity can lead to higher taxes and unnecessary compliance issues.
Overview of the Three Most Common Business Structures
When choosing a business entity for tax efficiency in the U.S., most business owners are deciding between three options.
These are LLC, S Corporation, and C Corporation.
Each structure has its own tax rules, benefits, and trade-offs. Understanding the basics of each one helps you narrow down what may work best for your situation.
1 - LLC (Limited Liability Company)
An LLC is one of the most popular business structures in the U.S. because of its flexibility and simplicity.
From a tax perspective, the IRS does not treat an LLC as a separate tax-paying entity by default. Instead, income passes through to the owner and is reported on the owner’s personal tax return.
However, LLC owners often overlook two critical tax issues: self-employment taxes and the temporary nature of current tax benefits.
An LLC is one of the most popular business structures in the U.S. because of its flexibility and simplicity.
From a tax perspective, the IRS does not treat an LLC as a separate tax-paying entity by default. Instead, income passes through to the owner and is reported on the owner’s personal tax return.
However, LLC owners often overlook two critical tax issues: self-employment taxes and the temporary nature of current tax benefits.
LLCs and the 20% QBI Deduction (Tax Cliff Warning)
Most LLC owners currently benefit from the 20 percent Qualified Business Income (QBI) deduction under the Tax Cuts and Jobs Act (TCJA). This deduction allows eligible pass-through business owners to deduct up to 20 percent of qualified income.
However, this deduction is scheduled to expire on December 31, 2025, unless Congress acts.
If the QBI deduction expires, many LLC owners could see a meaningful increase in effective tax rates starting in 2026. This “tax cliff” is one of the most important planning considerations when choosing or reevaluating an entity structure today.
2 - S Corporation
An S Corporation is not a business structure you form at the state level. It is a tax election made by the IRS.
The primary advantage of an S Corporation is payroll tax savings.
As an owner, you must pay yourself a reasonable salary subject to payroll taxes. Remaining profits can be distributed without self-employment tax.
S Corps and the TCJA Expiration
Like LLCs, S Corporations currently benefit from the 20 percent QBI deduction and lower individual income tax brackets created under the TCJA.
Both the QBI deduction and current individual tax rates are set to expire after December 31, 2025, unless extended by Congress.
This means the long-term tax advantage of an S Corporation may look very different after 2025, especially for high-income owners. Planning today without considering this expiration can lead to surprises later.
3 - C Corporation
C Corporations are separate legal and tax-paying entities.
They pay federal corporate income tax at a flat rate of 21 percent.
While double taxation is often viewed as a downside, C Corporations offer unique advantages that LLCs and S Corporations cannot.
Section 1202 Qualified Small Business Stock (QSBS)
One of the most powerful and often misunderstood advantages of a C Corporation is eligibility for Section 1202 Qualified Small Business Stock (QSBS).
If structured correctly, founders and early investors in a qualified C Corporation may be able to exclude up to 100 percent of capital gains on the sale of stock, subject to limits.
For many technology startups and high-growth companies, QSBS is the number one reason to choose a C Corporation. The potential for tax-free exit proceeds can outweigh years of higher compliance costs and double taxation concerns.
This benefit is not available to LLCs or S Corporations.
BOI Reporting Requirement (Corporate Transparency Act)
A major compliance requirement that applies regardless of tax strategy is Beneficial Ownership Information (BOI) reporting under the Corporate Transparency Act.
Most LLCs, S Corporations, and C Corporations are now required to report beneficial ownership information to FinCEN.
Failure to comply with can result in steep penalties, including significant daily fines and potential criminal exposure.
BOI reporting is not optional and is separate from tax filings. Many business owners are unaware of this requirement, which creates serious compliance risk if ignored.
LLC Taxation Explained
LLCs are popular because they are flexible and simple to run, but their tax treatment often surprises business owners as profits grow.
Understanding how LLCs are taxed helps you see when they are tax-efficient and when they may start costing you more than expected.
1. How LLCs Are Taxed by Default
By default, the IRS does not recognize an LLC as a separate tax entity.
Instead, LLC income passes through to the owner or owners and is reported on personal tax returns. If you are a single-member LLC, the IRS treats your business as a disregarded entity, meaning you report income on Schedule C with your individual return.
If your LLC has multiple owners, it is typically taxed as a partnership. The business files an informational return, and each owner reports their share of profit on their personal tax return. In both cases, the business itself does not pay federal income tax.
Pass-through taxation is simple and avoids corporate-level tax.
According to the IRS, pass-through entities account for the majority of U.S. business income, which is why LLCs are so widely used.
2. Self-Employment Taxes and LLC Owners
One of the biggest downsides of LLC taxation is self-employment tax.
As an LLC owner, all net business income is generally subject to self-employment tax, which covers Social Security and Medicare. This tax applies on top of regular income tax.
As of current IRS rules, self-employment tax is 15.3 percent on net earnings up to the Social Security wage base, with Medicare tax continuing beyond that threshold. The IRS reports that many LLC owners underestimate how much self-employment tax affects their take-home income as profits grow.
3. When an LLC Is the Most Tax-Efficient Choice
An LLC is often most tax-efficient during the early stages of a business.
If profits are relatively low, the simplicity of pass-through taxation can outweigh the impact of self-employment taxes. LLCs also work well for side businesses or companies with fluctuating income.
Many businesses remain in LLCs until profits reach a level where payroll tax savings from an S Corporation become meaningful.
According to CPA industry estimates, S Corp tax treatment often becomes beneficial when annual net profits reach approximately $40,000 to $60,000, depending on circumstances.
At lower profit levels, the cost and complexity of additional compliance may not justify a structure of change.
S Corporation Taxation Explained
An S Corporation can offer meaningful tax savings for the right business, but it also comes with stricter rules and ongoing responsibilities.
Understanding how S Corporation taxation works helps you decide whether the benefits outweigh the added complexity.
1. What Makes an S Corp Different
An S Corporation is created by making an election with the IRS.
Your business can be an LLC or a corporation at the state level and still choose S Corporation tax treatment.
Once the election is approved, the IRS taxes your business under special pass-through rules.
S Corporations have eligibility requirements. You must have no more than 100 shareholders, all shareholders must be U.S. individuals or certain trusts, and you can only issue one class of stock.
These rules limit flexibility but allow the IRS to apply specific tax advantages.
2. Pass-Through Taxation with Payroll Advantages
Like LLCs, S Corporations use pass-through taxation.
Business profits flow to your personal tax return and are taxed at individual rates. The key difference is how payroll taxes are applied.
As an S Corp owner, you are required to pay yourself a reasonable salary that is subject to payroll taxes.
Any remaining profit can be taken as distributions, which are not subject to self-employment tax. This structure can lead to significant savings as profits grow. The IRS closely monitors this area because of its impact on payroll tax revenue.
3. Reasonable Compensation Rules
The IRS requires S Corporation owners to pay themselves reasonable compensation for the work they perform.
This salary must be comparable to what someone else would earn for the same role. Paying too little salary to avoid payroll taxes increases audit risk.
According to the Treasury Inspector General for Tax Administration, misclassification of wages in S Corporations contributes to billions of unpaid payroll taxes each year.
Following reasonable compensation rules protect you from penalties and keeps your tax strategy compliant.
4. When an S Corp Makes Sense
S Corporation tax treatment often makes sense when your business generates consistent profits, and you are actively involved in operations.
Many tax professionals suggest that S Corp benefits become noticeable when net profits exceed a certain threshold, often around $50,000 annually, though this varies by situation.
If you plan to reinvest profits or scale gradually, the payroll tax savings can free up cash for growth. The key is balancing savings against the added cost of payroll, tax filings, and compliance.
C Corporation Taxation Explained
C Corporations are often misunderstood because of double taxation, but for some businesses, they can be one of the most tax-efficient structures available.
Understanding how C Corporations are taxed helps you see when this structure supports growth instead of creating an unnecessary tax burden.
1. How C Corporations Are Taxed
A C Corporation is a separate legal and tax-paying entity.
This means the business itself pays federal corporate income tax on its profits. Under current U.S. tax law, C Corporations are taxed at a flat federal rate of 21 percent.
After the corporation pays tax, any profits distributed to shareholders as dividends may be taxed again on the individual’s personal tax return. This is what people refer to as double taxation.
According to the Congressional Research Service, the flat corporate tax rate has made C Corporations more attractive for certain businesses that plan to reinvest earnings rather than distribute them.
2. When Double Taxation Is Not a Deal Breaker
Double taxation is not always a disadvantage. If your business plans to reinvest profits instead of paying dividends, the second layer of tax may be delayed or avoided altogether.
This allows more capital to stay inside the business to support growth.
Many high-growth companies choose C Corporation status for this reason.
A report from the Tax Foundation explains that reinvestment-focused companies can benefit from the lower corporate tax rate compared to higher individual income tax rates.
If your goal is to scale aggressively rather than maximize owner distributions, double taxation may not be a major concern.
3. When a C Corporation Is the Best Choice
A C Corporation often makes sense if you plan to raise venture capital, issue multiple classes of stock, or scale rapidly.
Investors typically prefer C Corporations because of their structure, governance, and exit flexibility.
C Corporations are also common for businesses planning long-term growth with reinvested earnings.
LLC vs S Corp vs C Corp — Side-by-Side Tax Comparison
Seeing the differences between an LLC, S Corporation, and C Corporation in one place makes it much easier to understand how each structure affects taxes and decision-making.
The table below highlights the most important tax and operational factors you should consider.
| Feature | LLC | S Corporation | C Corporation |
|---|---|---|---|
| How income is taxed | Pass-through to owner | Pass-through to owner | Taxed at the corporate level |
| QBI Deduction | Expires after 2025 | Expires after 2025 | Not Applicable |
| Federal income tax | Paid on the owner's personal return | Paid on the owner's personal return | Paid by the corporation at 21% |
| Self-employment/payroll taxes | All net profits are subject to self-employment tax | Payroll taxes only on a reasonable salary | Payroll taxes on wages paid |
| Distributions | Subject to self-employment tax | Not subject to self-employment tax | Dividends may be taxed again |
| Double taxation | No | No | Yes, in many cases |
| Complexity level | Low | Moderate | High |
| Ongoing compliance | Minimum | Payroll and additional filings | Corporate filings and formalities |
| Investor friendly | Limited | Limited | High |
| BOI Reporting | Required | Required | Required |
| Best for | Early-stage or low-profit businesses | Profitable owner-operated businesses | High-growth or investor-backed companies |
Non-Tax Factors You Must Consider
While taxes are a major part of choosing the right business entity, they should not be the only factor in your decision.
Your entity choice also affects legal protection, ownership flexibility, administrative workload, and state-level costs.
Ignoring these factors can create problems even if your tax strategy looks good on paper.
1. Legal Liability Protection
One of the main reasons business owners form an LLC or corporation is to protect personal assets.
When your entity is set up and maintained correctly, it helps separate your personal finances from business liabilities. This means your home, savings, and personal investments are generally protected if the business is sued or cannot pay its debts.
The U.S. Small Business Administration emphasizes that liability protection depends not only on the entity type but also on proper recordkeeping and compliance.
No matter which entity you choose, failing to follow formalities can weaken this protection.
2. Ownership Flexibility and Investor Needs
Your entity choice determines who can own part of your business and how ownership is structured.
LLCs offer flexibility in ownership and profit distribution, which can be helpful for small teams or family-owned businesses.
S Corporations are more restrictive, with limits on the number and type of shareholders.
C Corporations offer the most flexibility for raising capital. They allow multiple classes of stock and are typically preferred by investors.
If you plan to raise outside funding, this factor becomes especially important.
3. Administrative and Compliance Requirements
Each entity comes with a different level of administrative responsibility.
LLCs generally require fewer formalities and simpler ongoing compliance.
S Corporations require payroll processing, additional tax filings, and stricter documentation.
C Corporations have the highest compliance burden. They require corporate governance, board meetings, and more complex reporting.
According to the IRS, increased compliance often leads to higher professional service costs, which should be factored into your decision.
Choosing an entity that matches your capacity for administration helps avoid unnecessary stress and expense.
4. State-Level Taxes, Fees, and Regulations
State rules can significantly impact your entity's choice.
Some states charge annual franchise taxes or minimum fees based on entity type.
For example, certain states impose higher costs on corporations than LLCs, regardless of profitability.
The Tax Foundation notes that state-level business taxes and fees vary widely and can influence overall tax efficiency.
Because state laws differ, your entity's decision should always consider where your business operates, not just federal tax rules.
Conclusion
Choosing the right business entity is not just a legal step. It is a strategic tax decision that can affect your cash flow, growth, and long-term success.
With the TCJA tax cliff approaching, mandatory BOI reporting now in effect, and powerful tools like QSBS available only to C Corporations, entity selection has never been more important.
What worked in the past may not be optimal going forward.
At Virtue CPAs, we help business owners evaluate entity structures with a forward-looking lens that includes tax efficiency, compliance risk, and growth strategy.
If you are starting a business, scaling rapidly, or reassessing your current structure ahead of 2026, now is the time to act.
We help you evaluate entity options through the lens of tax efficiency, compliance, and growth strategy.
If you are starting a business, growing rapidly, or questioning whether your current entity still makes sense, now is the right time to get expert guidance.
Ready to make the right choice for your business?
Contact Virtue CPAs today to schedule a consultation.
Frequently Asked Questions
Rick Patel
