LLC vs S-Corp vs C-Corp for $500K+ Businesses
The comparison that matters is not which is best. It is which fits what you intend to do with the profit.
An LLC is a legal entity, while S-corp and C-corp are tax classifications, so the three are not strictly parallel choices. The practical question for a business earning $500,000 or more is how its profit should be taxed: as a pass-through without an S election, as a pass-through with one, or at the corporate level. The answer turns mostly on whether profit is distributed or retained.
Clearing Up the Categories
An LLC is formed under state law and provides liability protection. By default it is taxed as a sole proprietorship if it has one owner or a partnership if it has several. It can instead elect to be taxed as an S-corp or a C-corp without changing its legal form.
So the real menu is the tax treatment: default pass-through, Subchapter S, or Subchapter C. A corporation formed under state law faces the same choice between S and C. Framing the decision as LLC versus S-corp obscures that the same LLC can be either.
Default Pass-Through Taxation
Profit passes to the owners and is taxed on their personal returns whether or not distributed. For an actively involved owner, the entire share is generally subject to self-employment tax.
At $500,000 of profit that exposure is the main drawback. The advantages are real, though: no payroll requirement, no reasonable compensation analysis, flexible allocations between owners that need not track ownership percentages, and basis that includes the entity's debt, which supports loss deductions. That last feature is why real estate is nearly always held this way.
Subchapter S
Profit still passes through and is taxed personally, but only amounts paid as wages carry Social Security and Medicare tax. The rest is distributed free of those taxes.
At $500,000 to $1,000,000 the saving is the Medicare component, roughly 3.8 percent, because the Social Security wage base is already cleared by wages. On $500,000 of distribution that is around $19,000 a year.
The costs are a separate return, payroll infrastructure, a defensible reasonable compensation file, strictly pro-rata distributions, and shareholder eligibility restrictions. The disqualifying feature for many owners is that entity-level debt does not create basis.
Subchapter C
The corporation is a separate taxpayer paying a 21 percent federal rate on its income. Profit distributed as dividends is taxed again to the shareholder, which is the double taxation that makes C-corps unattractive for owners who take their profit out.
Where a C-corp becomes interesting is retained earnings. An owner reinvesting profit rather than distributing it pays 21 percent rather than a personal marginal rate above 37 percent. That gap funds growth from cheaper capital.
Two further features matter. C-corps can deduct the full cost of health coverage and a broader range of fringe benefits for owner-employees than pass-throughs can. And qualified small business stock under Section 1202 can, where all the requirements are met including a five-year holding period, exclude a substantial amount of gain on an eventual sale. For a company being built to sell, that provision alone can outweigh years of double taxation.
The Comparison That Actually Decides It
| Default pass-through | S-corp | C-corp | |
|---|---|---|---|
| Entity-level tax | None | None | 21% |
| Payroll tax on profit | Full share | Wages only | Wages only |
| Second tax on distribution | No | No | Yes, dividends |
| Debt creates owner basis | Yes | No | Not applicable |
| Allocations need not be pro rata | Yes | No | No |
| Owner fringe benefits | Limited | Limited | Broad |
| Section 1202 exclusion on sale | No | No | Possible |
| Suits retained earnings | Poorly | Poorly | Well |
Choosing by Intent
The decision follows from what the profit is for.
Taking the profit out. An S election is usually correct for an owner-operated business at this level. The payroll tax saving is real and there is no second layer of tax.
Holding appreciating property. Default partnership treatment, because debt creates basis and property can be distributed without triggering gain.
Reinvesting to build enterprise value. A C-corp deserves serious analysis, particularly where Section 1202 might apply at exit.
Unequal owner economics. Partnership treatment, because S-corps require strictly pro-rata distributions.
Many businesses at this level end up with more than one entity, because these intentions coexist: an S-corp operating company, a partnership holding the real estate, and occasionally a C-corp for a specific function.
Key Takeaways
- An LLC can be taxed as a partnership, an S-corp, or a C-corp; the legal form is not the tax choice.
- S election suits owners distributing profit; the saving at this level is the Medicare component.
- Only partnership treatment gives owners basis from entity-level debt, which real estate needs.
- C-corps suit retained earnings at 21 percent and may open Section 1202 treatment at exit.
- Many businesses at this level need more than one entity because the intentions coexist.
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Frequently Asked Questions
Which entity is best for a business making $500,000?
For an owner-operated business distributing its profit, an S election is usually correct. For a business retaining earnings to fund growth, a C-corp deserves analysis. For holding appreciating real estate, default partnership treatment is nearly always right. The intent for the profit decides it.
Is the 21% corporate rate lower than my personal rate?
Yes, but only on retained income. Distributing the profit as a dividend adds a second tax that generally erases the advantage. The corporate rate helps when earnings stay in the business to fund growth.
What is Section 1202 and does it apply to me?
Section 1202 allows exclusion of a substantial amount of gain on the sale of qualified small business stock, subject to requirements including C-corp status, an original issuance, a qualifying trade or business, gross asset limits, and a five-year holding period. It is relevant to companies being built for sale, and it requires planning from formation rather than at exit.
Can I change entity type later?
Yes, though the routes differ in cost. Electing S status from a partnership is straightforward. Converting to a C-corp is generally possible. Converting a C-corp back to a pass-through can trigger built-in gains tax for five years. Moving appreciated property out of a corporation is usually the expensive direction, which is why property should not be placed there to begin with.
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