Choosing the Right Entity Can Save (or Cost) You Thousands
When starting or growing a business, choosing the right legal structure is one of the most critical decisions you’ll make. Your business structure not only affects liability and management but also determines how your income is taxed. Whether you’re a sole proprietor, LLC, S corporation, partnership, or C corporation, the way your business is organized will impact your tax obligations, filing requirements, and deductions.
In this blog post, we’ll break down how each business entity impacts taxation and guide you in making tax-smart decisions that align with your business goals.
Why Business Structure Matters for Taxes
The IRS treats each business entity type differently. Your choice of structure affects:
How your income is taxed
Your eligibility for tax credits or deductions
Payroll taxes and self-employment taxes
How and when you file tax returns
Failing to choose the most tax-efficient structure for your situation could mean overpaying taxes and missing out on savings opportunities.
1. Sole Proprietorship
Overview:
A sole proprietorship is the simplest and most common business structure, especially for freelancers and solo entrepreneurs. There is no legal separation between the business and the owner.
Tax Impact:
All business income is reported on Schedule C of your personal tax return (Form 1040).
Subject to ordinary income tax rates and self-employment tax (15.3% for Social Security and Medicare).
No need to file a separate business tax return.
Pros:
✅ Easy setup
✅ Pass-through taxation
✅ Fewer formal requirements
Cons:
❌ No liability protection
❌ High self-employment tax burden
❌ Limited tax planning options
2. Partnership
Overview:
A partnership involves two or more people sharing ownership. Common among service firms (law, accounting, consulting), partnerships offer flexibility but come with shared liability.
Tax Impact:
Files an informational return (Form 1065), but does not pay income taxes itself.
Income, losses, deductions, and credits pass through to the partners via Schedule K-1.
Each partner includes their share of income on their personal tax return.
Partners pay self-employment tax on business income.
Pros:
✅ Pass-through taxation
✅ Flexibility in profit/loss distribution
✅ No double taxation
Cons:
❌ Joint liability
❌ Complex recordkeeping
❌ Self-employment taxes apply
3. Limited Liability Company (LLC)
Overview:
An LLC combines the liability protection of a corporation with the tax flexibility of a partnership or sole proprietorship. LLCs can be single-member or multi-member, and may elect corporate taxation.
Tax Impact:
By default:
Single-member LLCs are taxed like sole proprietorships.
Multi-member LLCs are taxed like partnerships.
LLCs can elect to be taxed as an S corporation or C corporation (via Form 8832 or 2553).
Members pay self-employment taxes on profits unless taxed as an S corp.
Pros:
✅ Liability protection
✅ Flexible taxation options
✅ Simplified compliance
Cons:
❌ Self-employment tax still applies
❌ Annual fees and state filings may vary
4. S Corporation
Overview:
An S corporation is a tax election—not a business type—that allows profits, losses, and some tax items to pass through to shareholders, while also offering payroll tax advantages.
Tax Impact:
Business files Form 1120S and issues Schedule K-1 to shareholders.
Owners pay themselves a reasonable salary, which is subject to payroll taxes.
Remaining profits (distributions) are not subject to self-employment tax.
Pros:
✅ Pass-through taxation
✅ Avoids double taxation
✅ Reduces self-employment tax
✅ Salary + distribution model offers planning flexibility
Cons:
❌ More IRS scrutiny
❌ Stricter qualification rules (e.g., one class of stock, max 100 shareholders)
❌ Payroll setup required
5. C Corporation
Overview:
A C corporation is a separate legal entity that pays taxes on its profits. Unlike pass-through entities, a C corp faces double taxation—once at the corporate level and again on shareholder dividends.
Tax Impact:
Files Form 1120 and pays a flat 21% federal corporate income tax (as of 2024).
Shareholders pay taxes again on dividends received.
No self-employment tax on dividends, but owners working in the business must draw a reasonable salary subject to payroll tax.
Pros:
✅ Flat tax rate
✅ Easier to raise capital
✅ Attractive for large or high-growth businesses
✅ Fringe benefits (health insurance, etc.) may be deducted
Cons:
❌ Double taxation
❌ More regulatory requirements
❌ Complex accounting and reporting
Comparative Overview
| Structure | Tax Filing | Income Taxed At | Subject to SE Tax? | Double Taxation? |
|---|---|---|---|---|
| Sole Proprietor | Form 1040 + Sch C | Owner’s return | Yes | No |
| Partnership | Form 1065 + K-1 | Partners’ returns | Yes | No |
| LLC | Varies (default or elected) | Member’s return or corp return | Yes (unless S corp) | Depends on election |
| S Corporation | Form 1120S + K-1 | Shareholders’ returns | Only on salary | No |
| C Corporation | Form 1120 | Corporate & Dividends | No (salary taxed) | Yes |
Which Structure is Best for Tax Savings?
There’s no one-size-fits-all answer. Your optimal structure depends on:
Income level
Number of owners
Plans for reinvestment vs. profit distribution
Long-term growth strategy
For solo entrepreneurs earning over $75,000 per year, an S corporation election can significantly reduce self-employment taxes.
For high-growth startups or those seeking outside investors, a C corporation might be best despite double taxation.
When to Reevaluate Your Structure
Your business evolves—so should your structure. Consider reevaluating your entity if:
You’re hiring employees
Revenue has increased substantially
You want to offer stock or attract investors
You’re considering selling or merging
Final Thoughts: Structure Your Business for Success
Choosing the right business structure isn’t just a legal decision—it’s a strategic tax move. The right setup can reduce your tax burden, improve compliance, and support long-term growth.
🚀 Need help selecting or changing your business structure?
At Tax Alternatives, we specialize in tax planning that aligns with your goals. Whether you’re just starting or restructuring, we’ll help you build a tax-smart foundation for your business.
📩 Fill out the form below to schedule your free consultation today!
