Choosing the Best Type of Entity and Tax Classification for Your Business

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Which is best, an S Corporation, C Corporation or LLC? An Update

No one type of entity is inherently better than another. Each person and business must consider a number of factors and apply them to his or her specific situation.
There is an important distinction between a type of legal entity and the types of tax classifications available to each entity. Many articles blur the lines between the two creating much of the confusion in the entity selection process.
You can’t make an intelligent decision on your best entity type or tax classification because an online incorporation service tells you that a certain percentage of people who responded to a series of questions with answers similar to yours chose a specific type of entity.


By far, the most common question that callers ask us is “which is better, a corporation or an LLC?” Frequently, the callers have done some research, but with each article read only become more confused.

Then there are callers who tell us emphatically that they want to form an LLC. Rather than just preparing the necessary paperwork, we ask some questions about their business and the people involved. We often turn the question around and ask why they have decided to form an LLC rather than a corporation. The responses are along the lines that “I’ve heard it’s easier/less expensive to form/operate an LLC,” or “I don’t want to have to hold meetings and do all the paperwork involved with a corporation.” These are just a couple of the misconceptions this article will discuss.

Perhaps the point of this article is best made by using a different context. If a stranger asked you “which is better, a pickup truck or a minivan,” your response would probably be “it depends.” You need additional information to make an intelligent recommendation, such as:

  • Howare you going to use the vehicle?
  • How many people do you need to transport?
  • Do you need a pickup bed for your work?
  • Will this be a family vehicle where you need the extra seating and entertainment features?

It’s no different when asking this question about a corporation and an LLC: neither type of entity is inherently better or worse than the other. To determine the “best” type of entity for you, you must analyze several factors that may be quite different in each situation. This article discusses those factors and their importance in making an informed decision on the best entity type and best tax classification for you and your business.

How to Use the Information in this Article

The purpose of this article is to provide you with a better understanding of the most common factors that are often overlooked in deciding between a corporation and an LLC as well as the best tax classification for that entity. These are complex issues which would require an exhaustive article to cover in full. This article should therefore be used as a starting point in a discussion with your legal or financial advisor to make the appropriate determinations in your case.

What you should take away from this article is that it is unlikely you can confidently decide on the best type of entity and best tax classification simply by reading information online, using an online interactive tool to learn “what others have chosen,” or following the recommendation of a friend or family member simply because they made certain choices for their business.

Understanding These Essential Principles Will Resolve Much of Your Confusion

Let’s start by clarifying some common misunderstandings many people have that contribute to the confusion about entities and tax classifications. Here are some essential principles to understand and keep in mind as you read the article:

1. Corporations and LLC’s are types of legal entities.

2. S Corporations and C Corporations are not types of legal entities; they are tax classifications under the Internal Revenue Code. When you hear someone refer to an “S Corporation,” it is usually a shorthand way of saying it is a corporation that has elected to be taxed under the S Corporation tax classification. Unfortunately, the average reader doesn’t understand this shorthand and is misled into thinking that one must form a corporation to be taxed under the S Corporation tax classification, which is not the case.

3. A corporation, when formed, is automatically assigned the C Corporation tax classification under the Internal Revenue Code.

4. An LLC, when formed, is automatically assigned a tax classification under the Internal Revenue Code based upon the number of members. A single-member LLC is automatically treated as a “disregarded entity.” This means the LLC does not file a separate federal tax return, but rather reports profits and losses of the business on the single member’s individual 1040 tax return, just like a sole proprietor. A multiple member LLC is automatically classified as a partnership for tax purposes under the Internal Revenue Code.

5. A corporation and an LLC may both choose to be taxed under either the C Corporation or S Corporation tax classification. The type of legal remains the same—only the tax classification changes to impact how the entity reports and pays taxes.

This is where many people become confused–an LLC may elect to be taxed under the C Corporation tax classification or S Corporation tax classification. How does this work? For all tax-related purposes, the C Corporation or S Corporation tax provisions apply. An LLC choosing to be taxed under the S Corporation tax classification therefore files federal income tax form 1120S, the same tax form that a corporation files when it elects the S Corporation tax classification. For all non-tax purposes, that is, when an issue involves the type of entity, the LLC remains an LLC. The owners always remain members, not shareholders; the governing document continues to be an operating agreement, not bylaws; the company is managed by the members or a manager, not by officers or directors (though an LLC has the option of appointing officers, they are required in a corporation).

Separating the Factors to Consider in Your Legal Entity and Tax Classification Decisions

This distinction between a type of legal entity and a tax classification is important because there are different factors to consider for each decision. There’s usually a balancing of advantages and disadvantages that must be done in each case to be confident in the decisions you’ve made. Let’s focus first on the factors involved in choosing between a corporation and an LLC.

Here are the major characteristics most often discussed in comparing corporations and LLC’s. Each is discussed in the paragraphs that follow:

1. Protection for Personal Assets

2. Management structure

3. Formation cost

4. Recordkeeping and ongoing maintenance requirements

Protection for Personal Assets

There’s a mistaken belief that an LLC offers better protection for your personal assets than a corporation. This no doubt arises from the fact that LLC is an acronym for “limited liability company.” The label “corporation” does not suggest any limited liability protection. Many people therefore assume that an LLC offers personal asset protection whereas a corporation does not. This is not the case. The general rule, with rare exceptions, is that shareholders in a corporation have the same personal liability protection for their assets as members in an LLC. Stated otherwise, members in an LLC will be protected from personal liability, or be at risk for personal liability, to the same extent as shareholders in a corporation.  Here’s an excerpt from the California LLC Act to this effect:

Corporations Code Section 17703.04 (b) states: “A member of a limited liability company shall be subject to liability under the common law governing alter ego liability, and shall also be personally liable under a judgment of a court or for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, under the same or similar circumstances into the same extent as a shareholder of a corporation…”

This statute also confirms that an LLC member will be subject to personal liability just as a shareholder in a corporation would for engaging in any tortious conduct (e. g. committing negligence or fraud) or “for an obligation that arises under contract” such as a personal guarantee signed by the member. The personal liability protection is therefore not absolute for either an LLC member or a shareholder in a corporation. There are circumstances in which this personal liability protection will be lost, either voluntarily (e.g., signing a personal guarantee) or by operation of law (e.g., a court determining an LLC member used the LLC to commit fraud).

The Management Structures of Corporations and LLCs

The People and Their Positions

This is usually the most important factor to consider in deciding between a corporation and an LLC, primarily because there is so much difference in the management structures of the two entities. The corporation structure has three components: shareholders (the owners), directors, and officers (president, treasurer and secretary). Corporate statutes contain a quite rigid and defined set of rules for corporations and the people in each of these positions. Their duties and responsibilities, powers and limitations on those powers, are described in detail in corporate statutes, and there is little ability to modify these provisions to tailor them to a specific type of business or relationship of the principals running the business.

The LLC management structure provides far greater flexibility. The owners in an LLC are called members. The members may also select one or more managers to run the business on a daily basis. If they do, it is called a manager-managed LLC. If there is no manager, it is a member-managed LLC. There is no board of directors, no shareholders, and generally no officers, though appointing officers is optional.

The Governing Documents: Bylaws and Operating Agreements

While the governing document in a corporation is its bylaws, the governing document in an LLC is called an operating agreement. It is very similar to a partnership agreement. With very few limitations, LLC statutes allow the members great latitude in customizing the provisions of their operating agreement to whatever extent they desire. This gives the members the opportunity to have an agreement prepared that is specific to their type of business and to the relationship of the members involved. Let’s look at an example of how this might work.

Let’s say Alice, Bob, Charlie and Denise are starting a new business together. It’s going to be a retail clothing store. They decide to form an LLC. They need to find a location, negotiate a lease, obtain financing, purchase product for inventory, formulate a plan for marketing and advertising, and establish a budget to keep control on expenses. They need to divide up these responsibilities.

In a corporation, the day-to-day management of the business would be done by the officers. The president would have the main authority for the business operations while the treasurer would have specific responsibilities for the financial affairs of the corporation and the secretary would have the primary responsibility for record keeping.

By forming a member-managed LLC with all four of them as members, they are able to create an operating agreement that gives them the ability to assign specific duties and responsibilities to one or more members, to specify the limits on the authority of any member acting alone in carrying out his or her responsibilities, and to describe the procedure for obtaining additional authority from the other members when necessary. For example, Alice may be given the authority to find a location for the store and to negotiate the terms of the lease, but the operating agreement may restrict her authority to sign the lease without first obtaining the approval of the other members.

Denise is a people person. The operating agreement can give her the responsibility for interviewing, hiring and firing employees. The operating agreement can set limits on the salaries and hourly wages Denise is authorized to pay to the employees, or the agreement can leave it to Denise’s discretion so long as she stays within the maximum amount for this expense in a budget approved by the members.

Bob is a numbers whiz. The operating agreement gives him the responsibility for creating a budget for approval by the members, for determining the amount of inventory the store should carry, the price points for the products to be offered and the profit margins that should be achieved on those products.

This level of detail would be extremely difficult if not impossible to cover in corporate bylaws and minutes. Keep in mind also, that this example deals only with the management structure of the business. There are many more topics that an LLC operating agreement can and should cover that go well beyond the topics covered in the bylaws of the corporation.

Formation Cost: Understanding All the Cost Factors

As a general rule, the formation cost for an LLC is slightly less than a corporation, though this can be misleading. Here’s why. Many people who form an LLC are doing so for the first time. They don’t fully understand all the components of an LLC or all the tasks that must be completed to properly form the LLC. Many don’t fully understand what an operating agreement is or its importance in the proper formation of the LLC.

This might be compared to having your accountant prepare a more complicated tax return for you. If you don’t have an accounting background, how could you know if all the proper schedules have been prepared, or whether the ones that were prepared are done properly?

Don’t Risk Overlooking Important Details By Simply Selecting a “Quick and Easy” Online Service

Many people use “the leading online legal document service” (that’s become a household name) to form a corporation or LLC because it’s “quicker and easier” than ever. After all, if you’ve never formed an LLC before, how would you understand whether the online questionnaire you’re completing is asking for all the information necessary to properly complete your documents? More importantly, how would be able to judge the quality of the operating agreement and other documents or forms you receive?

An Important Cost and Quality Factor: A “Personalized” vs. Truly Customized Operating Agreement

To that point, the “personalized” operating agreement you’ll receive is essentially a “one size fits all” in which the “personalization” consists of inserting the name of the LLC and the names of the members and their contributions and ownership percentages in what is essentially a standard form, “cookie cutter” operating agreement for every LLC. You don’t really understand the importance of the operating agreement or many of its provisions and there’s no reason you should. Perhaps you quickly read it or simply sign it (or not) without really understanding it and put it away.

The point here goes back to the example above for the retail clothing store. If you choose to form an LLC because of the flexible management structure it offers, you should have a customized operating agreement to document that flexibility. This can’t be provided by your garden-variety online incorporation service but can be provided by an attorney-owned and staffed company like Nationwide Incorporators. We offer both a shorter fully customized operating agreement as well as a comprehensive, fully customized operating agreement (typically for multiple members who are unrelated and want the additional details and provisions). This is equal to or better than you’d receive from comparable experienced corporate attorneys in a traditional law office, but at a fraction of the cost that will only slightly increase the total cost of your LLC over a corporation.

Recordkeeping and Ongoing Maintenance Requirements

This final factor in deciding between a corporation and an LLC requires dispelling another widely held misconception—that a corporation requires regular meetings and written minutes of those meetings and is therefore more burdensome than an LLC because of all the recordkeeping requirements. This has some truth, but is vastly overemphasized as a negative for choosing the corporation structure.

The Offsetting LLC Consideration: Costs for Changes to Your Operating Agreement

One factor that is often lost in all the concern about meetings and minutes is the ongoing maintenance of an LLC. In particular, if there are any changes in the members or managers, such as adding or removing people or changing ownership percentages, these must be documented. The operating agreement must be amended. If you received a “one size fits all” agreement, who’s going to do this? If you have to go to an attorney, you’ve blown any savings you might have realized if you chose an LLC over a corporation because you believed it would be less expensive than a corporation.

Meetings Are Never Required in a Small Business Corporation

The foremost point to understand is this: In a small business corporation, which typically is a privately held corporation with just one person or several people who constitute all of the shareholders, directors and officers, actual meetings of the shareholders and directors are never required. Instead, corporate statutes in every state allow meetings to be dispensed with completely if the parties simply prepare a simple written consent resolution approving the action to be taken.  Here are examples from the California Corporations Code:

Section 307(b) relating to directors’ meetings:

“An action required or permitted to be taken by the board may be taken without a meeting, if all members of the board shall individually or collectively consent in writing to that action and if
the number of members of the board serving at the time constitutes a quorum.”

Section 603(a) relating to shareholders’ meetings:

“Unless otherwise provided in the articles, any action that may be taken at any annual or special meeting of shareholders may be taken without a meeting and without prior notice, if a consent in
writing [is signed by shareholders who could have authorized the action if a meeting had been held].”

Preparing Corporate Minutes Are Simple and Not Time-Consuming

It is true that written minutes are still required, but these are neither difficult nor time-consuming to prepare. With our $350 formation package, we provide 2 years of customized minutes for free and provide a Resolution Checklist with a list of over 100 different activities and events to select from to document activities in corporate minutes. After 2 years, our services are not generally required because the simplicity of preparing minutes becomes clear.

The Factors to Consider in Choosing the Best Tax Classification for Your Business

Let’s now discuss the major factors you should consider in selecting the best tax classification for the entity you have chosen. The first part of the discussion will simply describe the characteristics of each tax classification. The second part will discuss the impact of a tax classification on each type of legal entity. Again, keep in mind that this discussion is for informational purposes and should not be used alone in selecting a tax classification. Please consult with your financial advisor in determining the best classification for your particular business.

Characteristics of the C Corporation Tax Classification

Under the C Corporation tax classification, losses remain with the corporation or LLC and are unable to be utilized by the shareholders or members because it is not a “pass-through” tax classification. Profits are taxed at the corporation or LLC level based on federal and state corporate tax rates. Year-end profits are generally paid to shareholders and members in the form of salaries as employees based on the value of the services they have provided. The salaries are subject to self-employment taxes as well as income taxes.

Double taxation may be an issue, but often can be eliminated through salary payments because salaries are deductible expenses that reduce the corporation’s and LLC’s taxable income. However, if there is a pattern of increasing salaries each year to eliminate taxable profits, there is a risk that the IRS will characterize salaries as “unreasonable” and reclassify a portion of this compensation as a dividend. A dividend is taxable income to the shareholder or member, but not a deductible expense to the corporation or LLC. In short, this reclassification results in double taxation.

Characteristics of the S Corporation Tax Classification

The S Corporation tax classification creates a “pass-through” tax entity where all profits and losses of the corporation or LLC flow through to the individual shareholder’s or member’s personal tax return. Losses may be used to offset certain types of income from other sources. Shareholder- or member-employees may be able to reduce their self-employment (SE) taxes by taking a portion of the profits of the business in the form of salary (subject to SE taxes), and the remaining portion of profits as a distribution (not subject to SE taxes).

To elect the S Corporation tax classification, certain eligibility requirements must be met. (Read “shareholders” to include “members” in the following list). These include a maximum of 100 shareholders, only one class of stock, and only certain types of shareholders (primarily individuals who are U.S. citizens or resident aliens, and certain types of trusts).

Tax Classifications Specific to Limited Liability Companies

The tax classifications available to an LLC vary based on the number of members, their relationship and the formation or residency state. The IRS automatically assigns specific tax classifications known as “default” classifications. Unless an LLC elects to be taxed as a corporation or provides otherwise in the operating agreement, profits and losses are passed through to the members in accordance with their percentage ownership interests. The LLC is does not pay taxes as an entity at the federal level.

The “Disregarded Entity” Classification for a Single-Member LLC

A single member LLC is automatically treated as a disregarded tax entity, the same as a sole proprietor, giving it pass-through tax treatment. In a community property state, spouses who are members can choose to be treated as a single member LLC or multiple-member LLC.

The Partnership Tax Classification for a Multiple-Member LLC

A multiple-member LLC is automatically taxed as a partnership. Each member’s allocable share of income is typically self-employment income, which is subject to self-employment taxes.

The Impact of Specific Tax Classification Choices for a Corporation and LLC

The LLC Default Tax Classifications Have Certain Advantages Over Corporation Tax Classifications

A corporation has two tax classifications available to it, the C Corporation and S Corporation classifications. The drawbacks of the C Corporation classification are discussed above. To avoid these with the S Corporation tax classification, the eligibility requirements highlighted previously must be met and maintained each year. Further, distributions of profits and losses to shareholders or LLC members with the S Corporation tax classification must be exactly in accordance with their respective ownership percentages.

The single member disregarded entity and multiple-member partnership classifications both have “pass-through” tax treatment that avoid the double taxation of profits that applies with the C Corporation tax classification. This pass-through treatment is achieved without having to meet the S Corporation eligibility requirements. For example, while the S Corporation tax classification is available only for individual owners who are U.S. citizens or resident aliens, and certain trusts, the LLC pass-through tax classifications are available regardless of the type of owners.

The LLC can also make disproportionate distributions of profits and losses to the members, which cannot be done with the S Corporation tax classification. In other words, if there are 3 shareholders in a corporation with an S Corporation tax classification each with a one-third ownership, any distribution of profits or losses must be exactly one-third to each shareholder. In an LLC with 3 members each owning a one-third ownership and taxed as a partnership, the operating agreement can provide for distributions of profits and losses as the members agree, notwithstanding their ownership percentages, so long as they are done within certain IRS restrictions. This may be attractive to a wealthy investor in a start-up business who is able to take a greater percentage of the initial losses than his or her ownership percentage in the LLC and use the losses to offset income from other sources.

The LLC also has advantages over a corporation because an LLC is not subject to certain penalty taxes that are imposed on corporations. These include the accumulated earnings tax, personal holding company taxes, as well as taxes on certain appreciated assets. These are technical tax provisions that are beyond the scope of this article.

The Potential Self-Employment Tax Advantage of the S Corporation Tax Classification

Where the members in an LLC and the shareholders in a corporation are both actively involved in the operation of the business, the S Corporation pass-through tax treatment may offer an advantage over the LLC pass-through taxation. All of the profit distributions to the active LLC member will generally be deemed to be earned income and subject to self-employment taxes, primarily Social Security and Medicare taxes. These SE taxes have a combined rate of 15.3%.

With the S Corporation tax classification, shareholder-employees or member-employees may take a portion of the company profits in the form of reasonable salaries and a portion of the profits in the form of distributions. Only the portion paid as reasonable salaries are subject to SE taxes.


You should now understand that making an informed and intelligent decision when choosing between a corporation and LLC, and the “best” tax classification for that entity, requires consideration of many factors. You need to balance pros and cons and possibly make some trade-offs to make the best choices for your particular business.

Part of this decision involves choosing the right online incorporation service. Here are some important questions you should ask to feel confident in your decision:

  • Is the information on the website authoritative, detailed, and informative?
  • If you call, do you know the credentials of the person on the other end of the phone who’s answering your questions?
  • Who’s preparing your documents and forms what are their credentials?
  • Who will I speak with if I have questions in the future and what will their credentials be?
  • If I need additional documents or changes to my original documents, who will prepare these for me?

When you select Nationwide Incorporators, you not only receive surprisingly inexpensive formation services that are also “quick and easy,” you have the confidence of knowing that all information, documents and forms you receive are provided exclusively by an experienced corporate attorney.

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Robert Stenson

Robert Stenson

Robert Stenson brings more than 30 years of experience practicing corporate, general business, and real estate law to his work helping clients navigate the entity formation process. A Boston native, he earned his undergraduate degree from Georgetown University and then moved west to pursue his law degree at UCLA. In addition to his experience in large law firms and corporate environments, Robert has also launched several small businesses of his own — all of which inform his personalized and comprehensive approach to helping entrepreneurs.

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