The Core Trade-Off
Every entity decision balances three factors: liability protection, taxation, and operational flexibility. No single entity wins on all three.
| Entity | Liability Protection | Taxation | Ownership Restrictions |
|---|---|---|---|
| Sole Proprietorship | None | Schedule C — ordinary income | Single owner |
| C-Corporation | Full | Double taxation (21% corp + dividend tax) | Unlimited shareholders, any type |
| S-Corporation | Full | Pass-through — one level | Max 100; US citizens/residents; one class of stock |
| LLC (as partnership) | Full | Pass-through — one level | Unlimited; can have foreign members |
| General Partnership | None (partners liable) | Pass-through — Schedule K-1 | Unlimited, but all bear liability |
C-Corporation: When It Wins
- Retaining earnings in the business: C-Corps pay a flat 21% corporate rate. If the owner doesn't need the cash personally, this can be lower than their personal marginal rate.
- Outside/institutional investors: VCs, pension funds, and foreign investors cannot hold S-Corp stock. C-Corp has no restrictions.
- Employee benefits: C-Corp owner-employees can deduct health insurance premiums as a business expense without the income limits that apply to S-Corps.
- Going public: Only C-Corps can have an IPO.
Exam Tip: C-Corps face "double taxation" — corporate profits taxed at 21%, then dividends taxed again at the shareholder level (0%, 15%, or 20% qualified dividend rate). S-Corps and LLCs avoid this second layer.
Personal Service Corporation (PSC)
- A C-Corp where substantially all activity is performing services in fields like law, health, consulting, accounting, or financial services.
- Taxed at a flat 21% rate — no graduated rates.
- Cannot use the graduated corporate rate brackets (which no longer exist post-TCJA anyway).
- Fiscal year restrictions may apply.
S-Corporation: When It Wins
- Pass-through taxation with limited liability — owner avoids double taxation.
- Losses pass through to shareholders (limited to basis).
- Owner-employee must pay themselves a reasonable salary — distributions above salary avoid payroll taxes.
S-Corp Restrictions (Memorize These)
- Maximum 100 shareholders
- Only one class of stock (but can have voting/non-voting shares)
- Shareholders must be US citizens or permanent residents
- Cannot be owned by another corporation, LLC, or most trusts (exceptions: grantor trusts, QSSTs, ESBTs)
LLC Taxed as Partnership: The Flexible Choice
- No S-Corp restrictions — can have unlimited members, foreign members, corporate members.
- Losses and profits pass through to members on Schedule K-1.
- Preferred for real estate investing (allows special allocations, step-up in basis on death of member).
- Members actively participating in the business may owe self-employment tax on distributive share.
- Single-member LLC = disregarded entity (Schedule C) unless elected otherwise.
Decision Tree
- Want to retain significant earnings in the business at low tax rate? C-Corp.
- Need pass-through + limited liability, small domestic workforce, no outside investors? S-Corp.
- Pass-through + flexibility + foreign/corporate investors + real estate? LLC as partnership.
- Simplest structure, one owner, no employees? Sole Proprietorship (but be aware of liability).
Memory Trick: "S-Corps are for Small, Simple, domestic setups (100 shareholders, 1 class, US residents). C-Corps are for Complex companies that want Capital (outside investors). LLCs are for Limited liability with unlimited flexibility."