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Learn the key differences between pass-through and corporate taxation, and how to choose the structure that saves your business the most.
You’ve probably heard other business owners debating S-Corps, LLCs, and C-Corps. And maybe you’ve wondered if you chose the right setup for your own business. Perhaps your accountant put you in an LLC years ago, but now that your company has grown, you’re second-guessing if that’s still the best choice. Or maybe you’re just starting out and feel overwhelmed by all the options.
- Which tax structure actually saves small business owners the most money?
- And how do you know when it’s time to change what you already have?
The entity structure you choose directly impacts how much you pay in taxes every single year. Make the wrong choice, and you could be overpaying by thousands. Make the right choice, and you'll keep more of your hard-earned profits.
In this article, we’ll explain how pass-through and corporate taxation work, where each structure shines (and where it falls short), and the common mistakes we see small business owners make.
By the end, you’ll understand the key differences between these two approaches and have a clear framework to decide which one is right for your business today… and as it grows.
Why Pass-Through Taxation Is the Default for Most Small Businesses
Let's start with the basics. Pass-through taxation means the business entity itself doesn't pay federal income tax. Instead, all the profits (or losses) "pass through" or “flow through” to you as the business owner, and you pay taxes on that income on your personal tax return.
Think of it like this: If your business makes $100,000 in profit, that $100,000 gets added to your personal income, and you pay taxes on it at your individual tax rate.
How S-Corporations Help Small Business Owners Save on Taxes
The most common pass-through entity for small businesses is an S-Corporation. Here's how it works:
- You form a regular corporation
- You elect "S-Corp status" with the IRS
- The corporation doesn't pay federal income tax
- All profits and losses flow through to you personally
The big advantage? You can save money on self-employment taxes. As an S-Corp owner, you pay yourself a reasonable salary (subject to payroll taxes), but any additional profits can be distributed to you without paying self-employment tax.
For example, if your S-Corp makes $150,000 in profit and you pay yourself a $60,000 salary, you'd only pay self-employment taxes on the $60,000 salary. The remaining $90,000 would be distributed to you as profit, avoiding those extra payroll taxes.
LLCs: Flexibility with Tax Elections
Limited Liability Companies (LLCs) offer incredible flexibility when it comes to taxation. By default, an LLC is taxed as a partnership (if you have multiple owners) or as a sole proprietorship (if you're the only owner). This means pass-through taxation.
But here's where it gets interesting: An LLC can elect to be taxed as an S-Corporation. You get the liability protection of an LLC with the tax benefits of an S-Corp. It's like having your cake and eating it too.
Most small businesses we work with end up being either:
- An LLC electing S-Corp taxation
- A traditional S-Corp
Both give you pass-through taxation benefits while allowing for strategic tax planning.
When Corporate Taxation Might Make Sense for Your Business
Most small businesses avoid C-Corporation taxation because of one major drawback: double taxation.
- First, the corporation pays a 21% federal tax on its profits.
- Then, when profits are distributed to you as dividends, you pay personal taxes on them again.
For many small business owners, that extra layer of tax outweighs the benefits. But there are a few situations where a C-Corp structure can be the smarter long-term choice:
- Exit Strategy (Section 1202 Benefits): If you plan to sell your business down the road, owning C-Corp stock for at least five years may allow you to exclude millions of dollars of gain from taxes.
- Raising Outside Capital: If you’re looking to attract investors or eventually go public, most investors prefer (or require) a C-Corp structure.
- Professional Corporations: Certain industries, like medical practices, may use professional C-Corp structures. These come with unique distribution rules that eliminate most double taxation issues, but they’re less common today.
For most small businesses, these exceptions don’t outweigh the downsides. But if your growth plans include outside investment or a future sale, a C-Corp could align better with your long-term strategy.
Examples of the Real-World Impact of Pass-Through vs. Corporate Tax
Let's look at how this plays out with real numbers. Imagine two identical businesses, each making $200,000 in annual profit:
Business A: S-Corporation (Pass-Through)
- Owner pays reasonable salary: $80,000 (subject to payroll taxes)
- Remaining profit distribution: $120,000 (no self-employment tax)
- All $200,000 is taxed at personal income tax rates
- Total tax burden: Approximately $45,000-55,000 (depending on personal tax situation)
Business B: C-Corporation (Corporate Taxation)
- Corporate tax on $200,000 profit: $42,000 (21% rate)
- Remaining after corporate taxes: $158,000
- If distributed as dividends: Additional personal tax of ~$24,000
- Total tax burden: Approximately $66,000
In this example, the S-Corp saves roughly $10,000-20,000 annually compared to the C-Corp structure.
How to Avoid the Biggest Mistake Small Business Owners Make
The biggest mistake we see is when business owners set up their entity structure once and never revisit it.
Your optimal tax structure can change as your business grows. A structure that worked when you were making $50,000 might be costing you thousands when you're making $500,000.
Common Pitfalls to Watch For:
- LLC without S-Corp Election: Many LLC owners are paying unnecessary self-employment taxes because they never elected S-Corp status.
- Wrong Entity for Growth Plans: If you're planning to bring in investors but you're set up as an S-Corp, you'll need to convert (which can be complicated and expensive).
- Ignoring State Tax Implications: Some states don't recognize S-Corp elections or have different rules that could impact your decision.
- Missing Election Deadlines: Tax elections have strict deadlines. Miss them, and you might be stuck with suboptimal taxation for an entire year.
Pass-Through vs. Corporate: How to Decide Which Business Structure Fits Your Business?
Here's a simple decision framework:
Choose Pass-Through Taxation (S-Corp or LLC with S-Corp Election) If:
- Your business makes consistent profits
- You want to minimize self-employment taxes
- You're not planning to raise significant outside capital
- You want flexibility in profit distributions
Consider Corporate Taxation (C-Corp) If:
- You're planning a long-term exit strategy (5+ years)
- You need to raise outside investment capital
- You're comfortable with more complex tax planning
- The Section 1202 benefits outweigh the double taxation concerns
Red Flags That Suggest You Need Professional Help:
- Your tax bill keeps increasing faster than your profits
- You're not sure if your current structure is optimal
- You're planning major business changes (new locations, partners, etc.)
- You haven't reviewed your entity structure in over two years
Making the Right Business Structure Choice for Your Future
Choosing between pass-through and corporate taxation is one of the most important financial decisions you’ll make as a business owner. Get it right, and you could save thousands each year. Get it wrong, and you might be giving the IRS more than you need to.
For most small businesses, pass-through structures like S-Corps or LLCs (with an S-Corp election) deliver the right balance of protection and tax savings. But if your long-term plans include raising investors or preparing for an eventual sale, a C-Corp could be the smarter fit, despite the extra complexity.
The key is that this isn’t a one-time decision. Your entity structure should evolve as your business does. What worked when you were making $50,000 might not be the best setup when you’re making $500,000.
If you’re ready to take the next step, here are two ways we can help:
- Keep Learning → Check out "Is an S-Corp or LLC Best for My Business?"or "S-Corp vs. LLC Tax Advantages" for a deeper look into pass-through options.
- Get Clarity Now → Use the pop-up "Takeour Entity Structure Quiz" in the bottom right of your screen to quickly see if your current setup is costing you money.
At Patrick Accounting, we help business owners revisit this decision at critical stages of growth. If you’re wondering whether your current setup is still serving you (or if it’s quietly costing you), let’s have a conversation and see if we’re the right fit to help.
