C Corps vs. LLCs Taxed as Partnerships

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Updated September 19, 2022
Angel Investing

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C Corporation Advantages/LLC Disadvantages

  • Traditional venture capital investments can be accepted. The issuance of convertible preferred stock by C corporations is the typical vehicle for venture capital investments. Venture capitalists typically will not invest in LLCs and may be precluded from doing so under their fund documents.

  • Traditional equity compensation is available. C corporations can issue traditional stock options and incentive stock options. It is more complex for LLCs to issue the equivalent of stock options to their employees. Incentive stock options also are not available to LLCs.

  • Ability to participate in tax-free reorganizations. C corporations can participate in tax-free reorganizations under IRC Section 368. LLCs cannot participate in tax-free reorganizations under IRC Section 368. This means that if you think your business may get acquired by a company in exchange for the acquiror’s stock, a C corporation would be a good choice of entity.

  • Qualified small business stock benefits. C corporations can issue qualified small business stock. LLCs cannot issue qualified small business stock. Thus, LLC owners are ineligible for qualified small business stock benefits, which is the 100% gain exclusion of up to $10 million on the sale of qualified stock held for more than five years, and the ability to roll over gain on the sale of qualified stock into other qualified stock.

  • Self-employment taxes. C corporation shareholders are not subject to self-employment taxes on the corporation’s income. An LLC’s members are generally subject to self-employment tax on their distributive share of the LLC’s ordinary trade and business income.

  • Retention of earnings/reinvestment of capital. A C corporation’s income does not flow or pass through to its shareholders; this makes it easier to retain and accumulate capital because a C corporation will never have to distribute cash to its stockholders so that they can pay the tax on the entity’s income. LLC’s pass-through taxation can make conservation of operating capital difficult. LLCs typically distribute cash to enable members to pay the taxes on their share of the LLC’s income (LLC members are taxed on the income of the LLC allocated to them regardless of whether any cash is distributed to them).

  • Fringe benefits. C corporations have more favorable treatment of fringe benefits. LLC members cannot be considered “employees” for federal income tax purposes and therefore must pay self-employment taxes; fringe benefits of LLC members are generally included in income.

  • State income tax return filing requirements. Each member of the LLC may be required to file a tax return in multiple states. This is not the case with C corporations.

  • Complexity/uncertainty. The flexible nature of LLCs makes them more complex. Partnership tax is also substantially more complex than C corporation tax. The relatively new nature of the LLC form and limited amount of case law make LLC transactions more complex and uncertain than their corporate counterparts.

  • Tax rates. Individual income tax rates can be higher than the highest stated corporate tax rates. At the time of this writing, the top C corp tax rate was 21%, and the top individual income tax rate was 37%.

  • Administrative burdens. Partnership tax accounting is more complex than C corporation accounting.

  • Withholding on foreign members’ distributive shares. An LLC has to withhold taxes on certain types of income allocated to foreign persons, regardless of whether distributions are made. C corporations are not subject to this requirement.

LLC Advantages/C Corporation Disadvantages

  • Single level of tax. LLCs are pass-through entities: their income is subject to only one level of tax, at the member level. A C corporation’s income is subject to tax, and any “dividend” distributions of earnings and profits to shareholders that have already been taxed at the C corporation level are also taxable to the shareholders (i.e., income is effectively taxed twice).

  • Pass-through of losses. Generally, losses, deductions, credits, and other tax benefit items pass-through to an LLC’s members and may offset other income on their individual tax returns (subject to passive activity loss limitation rules, at-risk limitation rules, basis limitation rules, and other potential limitations). A C corporation’s losses do not pass-through to its shareholders.

  • Tax-free distributions of appreciated property. An LLC can distribute appreciated property (e.g., real estate or stock) to its members without gain recognition to the LLC or its members, facilitating spin-off transactions. A C corporation’s distribution of appreciated property to its shareholders is subject to tax at the corporate level and possibly tax at the shareholder level as well. (It is for this reason that entities formed to invest in real estate or the stock of other companies should not be C corporations).

  • Tax-free formation. Appreciated property can generally be contributed to LLCs tax-free under one of the broadest nonrecognition provisions in the IRC (IRC Section 721). Tax-free capitalizations for C corporations must comply with the more restrictive provisions of the IRS to be tax free (i.e., IRC Section 351) (although this is not usually a problem).

S Corps vs. LLCs Taxed as Partnerships

S Corporation Advantages/LLC Disadvantages

  • Sales of equity. S corporations can more easily engage in equity sales (subject to the one class of stock and no entity shareholder restrictions, generally) than LLCs. For example, because an S corporation can only have one class of stock, it must sell common stock in any financing (and this makes any offering simpler). An LLC will have to define the rights of any new class of stock in a financing, and this may involve complex provisions in the LLC agreement and more cumbersome disclosures to prospective investors. In addition, an S corporation does not have to convert to a corporation to issue public equity (although its S corporation status will have to be terminated prior to such an event). As a practical matter, an LLC will likely need to convert to a corporation before entering the public equity markets, because investors are more comfortable with a “typical” corporate structure.

  • Traditional equity compensation available. S corporations can adopt traditional stock option plans; in addition, they can grant incentive stock options. It is very complex for LLCs to issue the equivalent of stock options to their employees (although they can more easily issue the equivalent of cheap stock through the issuance of profits interests—see below). Incentive stock options also are not available for LLCs.

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