C Corporation or LLC? How Entity Choice Affects Founders' Taxes and QSBS Eligibility

The entity you form on day one shapes how profits are taxed, what investors expect, and whether a future exit can qualify for the qualified small business stock exclusion.

Entity choice is one of the first decisions a founder makes and one of the hardest to reverse cheaply. The Silicon Valley default, a Delaware C corporation, fits most venture-backed startups, but a consulting practice or a profitable software tool with no plans to raise capital may be better served by an LLC.

How each entity is taxed

A C corporation is a separate taxpayer. Its profits are taxed at the 21% federal corporate rate, and in California at 8.84% for most corporations. When profits are distributed as dividends, shareholders pay tax again, though that double taxation matters little for a startup that reinvests everything.

An LLC is a pass-through by default. Profits and losses flow to the owners' personal returns, where they are taxed once at individual rates. Owners who actively work in the business generally owe self-employment tax on their share, which the IRS sets at 15.3% up to the Social Security wage base and 2.9% above it. Pass-through owners may also qualify for the Section 199A deduction of up to 20% of qualified business income, which the 2025 tax legislation made permanent, subject to income-based limits that phase out the benefit for many high-earning professionals in specified service fields.

California adds an $800 annual tax on every LLC plus a gross-receipts fee that begins at $900 for total income of $250,000 and rises to $11,790 at $5 million or more. Corporations owe the same $800 minimum franchise tax, though newly formed corporations are exempt in their first taxable year. An S corporation election, available to either form with restrictions, produces pass-through treatment with a 1.5% California entity-level tax and lets owners split income between wages and distributions, subject to the reasonable compensation rules discussed in a separate Insights article.

The QSBS factor

For founders expecting a meaningful exit, the qualified small business stock exclusion may outweigh every other consideration. Section 1202 defines qualified small business stock as stock in a C corporation originally issued to the holder that meets an active business requirement, among other tests. LLC interests and S corporation stock do not qualify. Under the 2025 changes, stock acquired after July 4, 2025 can earn a 50%, 75%, or 100% federal exclusion after three, four, or five years, capped at the greater of $15 million per issuer or ten times basis, with the gross assets ceiling raised to $75 million.

Consider a hypothetical. Two founders each build a company worth $30 million at exit and each own a third. The founder of a C corporation that qualified from inception may exclude the entire $10 million of gain from federal tax. The founder of an LLC pays federal capital gains tax at up to 20% plus the 3.8% net investment income tax, a difference of more than $2 million. Both pay California tax, which does not conform to the exclusion, so the state result is the same either way.

Converting later

An LLC can convert to a C corporation, and doing so before raising venture capital is common. The conversion can be structured so that the stock received qualifies as QSBS, with a wrinkle: for purposes of the exclusion, the holding period begins at conversion, and under Section 1202(i) the stock takes a basis equal to the property's value at contribution, so gain that accrued while the business was an LLC generally does not qualify. The gross assets test is also applied at conversion, so a business that has already grown large may find the door closed. Forming a C corporation early is often simpler than converting later.

What investors expect

Venture funds and most institutional angels invest almost exclusively in C corporations, partly because their limited partners are poorly suited to receive pass-through income and partly because the standard preferred stock structure requires a corporation. A founder who plans to raise from those sources will usually need a C corporation regardless of tax preferences.

Trade-offs in summary

The C corporation offers QSBS eligibility, investor compatibility, and simple equity compensation at the cost of potential double taxation and no pass-through of early losses. The LLC offers single-level taxation, flexibility, and a possible 20% deduction on profits at the cost of self-employment tax, California fees, and no QSBS. The right choice depends on the business's expected path and its need for outside capital.

This article is educational only and does not constitute tax, legal, or investment advice; founders should consult a qualified attorney and tax professional before choosing or changing an entity.

Important Disclosures

Important Disclosures: Propulsion Capital Management is an investment adviser registered with the State of California Department of Financial Protection and Innovation. Registration does not imply a certain level of skill or training. This article is provided for general informational and educational purposes only and does not constitute investment, tax, legal, or accounting advice, nor an offer or solicitation to buy or sell any security or to adopt any particular investment strategy. The information is believed to be accurate as of the date of publication but is subject to change without notice; tax laws and regulations change frequently and their application depends on individual facts and circumstances. Nothing herein should be relied upon as a substitute for personalized advice from a qualified professional. Investing involves risk, including the possible loss of principal, and past performance is no guarantee of future results. Diversification does not ensure a profit or protect against loss. Any examples are hypothetical, are for illustrative purposes only, and do not reflect the experience of any client. Links to third-party websites are provided for convenience; Propulsion Capital Management does not endorse, and is not responsible for, the content of third-party sites. Propulsion Capital Management does not provide tax or legal advice; please consult your tax adviser or attorney regarding your specific situation.