An LLC is a legal form, not a tax choice. The tax question is separate: whether the business’s profit is taxed on your own return, as a partnership or sole proprietor, as an S corporation, or inside a C corporation that pays its own tax. Most small service businesses end up with an LLC taxed either on the owner’s return or as an S corporation. A C corporation suits a business that keeps its profits in to grow, or that is raising outside investment.
An LLC is a wrapper, not a tax status
The most common misunderstanding is that forming an LLC decides how the business is taxed. It decides liability and ownership under state law. The tax treatment is chosen separately, and if nothing is chosen, a default applies.
A single owner LLC is, by default, disregarded for income tax. Its profit goes on the owner’s Schedule C, exactly as if there were no LLC, which is covered in what a Schedule C actually asks you for. An LLC with two or more owners is, by default, a partnership filing Form 1065, and each owner receives a K-1.
Either kind of LLC can instead elect to be taxed as a corporation, and then as an S corporation. So the real choice is not LLC or corporation. It is which of three tax treatments the business uses.
Taxed on your own return
As a sole proprietor or partnership, the business pays no income tax itself. The profit is taxed on the owners’ returns whether or not it is taken out, and it is subject to self employment tax.
Owners can generally claim the qualified business income deduction, of up to 20 percent of qualified business income, subject to limits. It is one of the reasons this treatment stays attractive for smaller businesses.
An S corporation
An S corporation also passes its profit through to the owners’ returns, on Form 1120-S. The difference is that an owner who works in the business is paid a salary through payroll, and profit above that salary is not subject to self employment tax.
That saving has costs attached: payroll run through the year, a separate return, and a salary that has to be defensible. How that salary is set is covered in reasonable compensation for an S corporation owner, and the mechanics in payroll for a one person S corporation.
There is also a question of whether it is allowed at all. An S corporation may have no more than 100 shareholders, only one class of stock, and only eligible shareholders. A nonresident alien cannot be a shareholder. So for a founder planning to bring in a partner who lives abroad, the answer is not that an S corporation is unwise. It is unavailable.
The reasons we say no to an S corporation are usually one of three: a foreign shareholder, plans to bring in investors with different rights to profits, which one class of stock does not allow, or profit too small to carry the payroll and the second return.
A C corporation
A C corporation pays its own tax on Form 1120, at a flat 21 percent of taxable income. When it pays dividends to its owners, those are taxed again on their returns. That second layer is what people mean by double taxation.
It is actually the right choice when profit is staying in the business to be reinvested, because the corporate rate applies and there is no second tax until money comes out. It is also the usual form for a company raising venture investment, and it can have foreign shareholders and more than one class of stock.
It is usually the wrong choice for a service business that pays out its profit to the owner every year. The profit is taxed twice, and the qualified business income deduction does not apply to a C corporation.
Questions people ask about LLCs and corporations
Is an LLC an S corp or a C corp?
Neither, unless it chooses to be. By default a single member LLC is disregarded and an LLC with two or more members is a partnership, which is how the IRS classifies an LLC that has made no election. It becomes a C corporation for tax purposes only by electing that on Form 8832, and an S corporation only by electing that on Form 2553. The legal entity stays an LLC either way.
How do I know how my LLC is taxed?
Look at the return it files. Its profit on a Schedule C on your own return means it is disregarded. A Form 1065 means a partnership, a Form 1120-S means an S corporation, and a Form 1120 means a C corporation. Where an election was made, the IRS sent a letter accepting it, and that letter belongs with the company’s permanent records.
Can a C corp own an LLC?
Yes. A corporation can be the only member of an LLC, and unless that LLC elects otherwise it is disregarded: its income and expenses go on the corporation’s own return, as a division of the corporation rather than a separate taxpayer. Where a corporation is one of two or more members, the LLC is a partnership by default and files its own return, with the corporation receiving a K-1 like any other partner.
The mistake that costs the most
The most expensive entity mistake is not choosing the wrong one. It is forming the entity the internet recommended and never running it as one.
An S corporation with no payroll. Personal spending paid from the business account. No separate books. Each of these undermines the reason the entity exists, and fixing them after the fact costs more than setting them up properly at the start.
Why this is decided in the fall
An entity change usually takes effect at the start of a tax year, and an S corporation election has its own deadline. Deciding in October leaves time to form the entity, open accounts, set up payroll, and file the election before January. How the election itself works is covered separately. Choosing, forming and running the right entity is part of what the business service covers.