Business Entity Tax Guide: Choosing the Right Structure for Tax Efficiency
The right business entity can save tens of thousands in annual taxes. Or cost you that much if chosen wrong. This guide breaks down LLC, S-Corp, C-Corp, and Partnership tax treatment with specific examples.
What You Need to Know About Entity Selection
Same business, different entity, different tax bill. S-Corps work best for profitable service businesses with $60K+ net income. C-Corps suit businesses planning to reinvest profits or seek VC funding. Partnerships offer flexibility for multi-owner businesses. Single-member LLCs taxed as sole proprietorships are simple but expensive once profitable. Most business owners choose entity based on liability, not taxes. That’s backwards.
Key Takeaways: Entity Selection at a Glance
- Sole Prop/Single-Member LLC: Simple but all net income subject to 15.3% self-employment tax
- S-Corporation: Best for $60K+ net income. SE tax only on salary, not distributions
- C-Corporation: 21% flat rate. Best when reinvesting profits, seeking VC, or planning QSBS exit
- Partnership: Flexible allocations, pass-through taxation, good for multi-owner businesses
- QBI Deduction: Up to 20% deduction for pass-through entities (not C-Corps)—now permanent under OBBBA
- Key Mistake: Choosing based on liability only, ignoring tax implications
Why Entity Selection Matters
The business structure you choose determines how much you pay in taxes. Same revenue. Same expenses. Same profit. Different entity. Different tax bill. The difference can be tens of thousands of dollars annually.
Entity choice affects self-employment tax, payroll tax, income splitting opportunities, and qualification for deductions like QBI. The “default” (sole proprietor or partnership for multi-member LLCs) is rarely optimal for profitable businesses. Wrong entity is expensive to fix. Dissolution, asset transfers, new formation. That’s money and time you don’t get back.
Hypothetical Illustration: Same Income, Different Structures
A consultant earning $150,000 net income:
Note: Actual savings depend on state taxes, deductions, and specific circumstances. This illustrates the concept.
The Real Cost of Getting It Wrong
Most business owners choose entity based on liability protection alone. Liability protection is table stakes. Every LLC and corporation provides it. Tax efficiency is the differentiator. A business owner paying $10K more annually in taxes for 5 years has lost $50K. That’s before accounting for what that money could have earned invested elsewhere.
Business Entity Tax Comparison
This table summarizes the key tax differences between entity types. Scroll right on mobile to see all columns.
| Factor | Sole Prop | Single-Member LLC | S-Corporation | C-Corporation | Partnership |
|---|---|---|---|---|---|
| Self-Employment Tax | All net income | All net income | Salary only | None | All net income (default) |
| Tax Return | Schedule C | Schedule C | Form 1120S | Form 1120 | Form 1065 |
| Owner Taxation | Personal | Personal | K-1 to personal | Salary + dividends | K-1 to personal |
| Double Taxation | No | No | No | Yes (potentially) | No |
| QBI Deduction | Yes | Yes | Yes | No | Yes |
| Reasonable Salary | N/A | N/A | Required | Required | N/A |
| Ownership Limits | N/A | N/A | 100 shareholders, no foreign | Unlimited | None |
| Basis Complexity | Low | Low | High | Medium | High |
Note: Multi-member LLCs default to partnership taxation unless they elect S-Corp or C-Corp treatment.
Sole Proprietorship and Single-Member LLC: Simple but Expensive
The default structure for single-owner businesses. Simple to form. Simple to operate. But expensive once you’re profitable.
How It Works
All net income flows to your personal return on Schedule C. All of it is subject to self-employment tax: 15.3% up to the Social Security wage base ($168,600 in 2024), then 2.9% Medicare tax above that. An LLC with one owner is treated identically for tax purposes unless you elect otherwise.
The Math Problem
Earn $100,000 net? You’re paying roughly $15,000 in self-employment tax before income tax even starts. That’s the government’s share of Social Security and Medicare. As an employee, your employer pays half. As a sole proprietor, you pay both halves.
When It Makes Sense
- Just starting out
- Net income under $40K
- Testing business viability
- Minimal compliance burden needed
- Side hustle while employed
When to Change
- Net income over $60K consistently
- Expect continued profitability
- Willing to run payroll
- Ready for more compliance
- SE tax savings exceed costs
The LLC adds liability protection but no tax difference (unless elected otherwise). The legal structure and tax treatment are separate decisions. You can be an LLC and elect S-Corp taxation. That’s often the best of both worlds.
Learn more: S-Corporation Tax Guide | S-Corp Tax Calculator
S-Corporation: The Tax-Saving Workhorse for Profitable Businesses
The S-Corp isn’t a different legal structure. It’s a tax election. File Form 2553 with the IRS, and your LLC or corporation gets taxed under Subchapter S. The key benefit: self-employment tax savings.
How S-Corp Taxation Works
As an S-Corp shareholder-employee, you split your income two ways:
- Reasonable salary: Subject to payroll taxes (Social Security + Medicare)
- Distributions: Not subject to employment taxes
The salary portion gets taxed like any employee. The distribution portion? Just income tax. No employment tax. That’s where the savings come from.
Typical S-Corp Savings Example
Net income: $150,000 | Reasonable salary: $80,000 | Distributions: $70,000
In reduced self-employment taxes vs. sole proprietor structure
The Reasonable Salary Requirement
This is where S-Corp owners get into trouble. The IRS requires a “reasonable salary” for shareholders who work in the business. Reasonable means what you’d pay someone else to do the same work. Too low? Audit magnet. Too high? You’ve negated the S-Corp benefit.
IRS Reasonable Salary Factors
The IRS looks at: industry norms, comparable wages for similar work, your hours and responsibilities, geographic location, company profitability, and what you paid employees doing similar work. “Zero salary” or “$12,000 salary” for a full-time consultant earning $200K will trigger scrutiny.
S-Corp Eligibility Requirements
- 100 or fewer shareholders
- One class of stock only
- No foreign shareholders
- No corporate or partnership shareholders (with limited exceptions)
- Domestic corporation or LLC
When S-Corp Makes Sense
- Service businesses (consulting, professional services, agencies)
- Net income consistently over $60K
- Single owner or small owner group
- No plans to raise VC capital
- Regular distributions to owners
When S-Corp Doesn’t Make Sense
- Planning to raise venture capital (VCs want C-Corps)
- Need multiple classes of stock
- Foreign shareholders in the mix
- Net income under $40K (compliance costs exceed savings)
Related resources: Complete S-Corporation Tax Guide | S-Corp Tax Services | S-Corp Calculator | S-Corp Retirement Strategies
C-Corporation: When Double Taxation Actually Makes Sense
C-Corps pay tax at the entity level (21% flat rate). When profits are distributed as dividends, shareholders pay tax again. That’s “double taxation.” Sounds terrible. But the math can actually work in specific situations.
The 21% Flat Rate Advantage
The Tax Cuts and Jobs Act set the corporate rate at 21%. Your personal rate on the same income? Could be 32%, 35%, or 37% at the top brackets. If you’re reinvesting profits into the business rather than distributing them, the C-Corp rate wins.
QSBS: The Exit Strategy Tax Break
Qualified Small Business Stock (QSBS) exclusion can exclude up to $15 million (or 10x your basis) in gain from federal tax when you sell C-Corp stock. For stock acquired after July 4, 2025 under OBBBA, new tiered exclusions apply: 50% after 3 years, 75% after 4 years, 100% after 5 years. The gross asset threshold also increased to $75 million. That’s massive for founders planning an exit. S-Corps don’t qualify.
When C-Corp Makes Sense
- Raising venture capital or institutional investment
- Planning to reinvest most profits
- Targeting QSBS exclusion for future exit
- Need multiple stock classes (common + preferred)
- Foreign shareholders present or planned
When C-Corp Doesn’t Make Sense
- Service businesses distributing profits
- Regular owner distributions needed
- Lifestyle business, not targeting big exit
- Want QBI deduction (C-Corps don’t qualify)
- No need for multiple stock classes
Accumulated Earnings Tax Risk
C-Corps that retain “unreasonable” amounts of earnings face a 20% accumulated earnings tax. The IRS doesn’t want you using C-Corp status just to defer personal income tax indefinitely. Have a documented business purpose for retained earnings.
2026 Tax Law Update: OBBBA Changes
The One Big Beautiful Bill Act (OBBBA), signed July 4, 2025, made individual tax rates permanent. The 21% corporate rate remains stable, and top individual rates (37%) are no longer scheduled to expire. C-Corp reinvestment strategy remains attractive when you don’t need regular distributions. QSBS rules also improved significantly—see above.
Related resources: Form 5471 Foreign Corporation Filing | Form 5472 Foreign-Owned Business
Partnership: Flexibility for Multi-Owner Businesses
Multi-member LLCs default to partnership taxation. So do general partnerships and limited partnerships. Pass-through taxation with maximum flexibility for allocating income among owners.
How Partnership Taxation Works
The partnership files Form 1065. Each partner gets a Schedule K-1 reporting their share of income, deductions, and credits. No entity-level tax. Everything flows through to the partners’ personal returns.
Special Allocations: The Flexibility Advantage
Unlike S-Corps (which must allocate pro-rata by ownership), partnerships can allocate income and losses differently than ownership percentages. One partner gets 60% of the income despite owning 40%? Allowed, with proper documentation and economic substance.
The Self-Employment Tax Issue
General partners typically pay self-employment tax on their distributive share. Limited partners may avoid SE tax on their distributive share (but not guaranteed payments). This is a complex area with IRS scrutiny. Structure matters.
When Partnership Works Best
- Multiple active owners
- Need flexible profit allocations
- Real estate investments
- Venture funds and investment structures
- Planning to add/remove partners
Consider S-Corp Election Instead When
- All owners work actively in business
- Equal ownership, equal work
- Want SE tax savings
- Don’t need special allocations
- Fewer than 100 shareholders
Related resources: Complete Partnership Tax Guide | Partnership Tax Services | Form 1065 Preparation | Schedule K-1 Services | Foreign Partnership Guide
Entity Selection Decision Framework
Use this step-by-step approach to narrow down your entity options. Each question eliminates certain structures and points toward the right choice for your situation.
How Many Owners?
Owner count affects available structures and complexity.
Are You Raising Outside Capital?
VCs and institutional investors have strong preferences.
What’s Your Annual Net Income?
Income level determines whether S-Corp complexity is worth it.
Do You Need Flexible Profit Allocations?
S-Corps require pro-rata allocation by ownership. Partnerships don’t.
Are Any Owners Foreign Nationals?
S-Corps cannot have foreign shareholders.
Planning to Reinvest Most Profits?
Distribution patterns affect optimal structure.
Not Sure Which Entity Is Right?
We’ll analyze your specific numbers. Show you the tax impact of each structure. Give you a recommendation and implementation roadmap.
Get Free Entity Analysis Try S-Corp CalculatorState Tax Considerations for Entity Selection
Federal tax treatment is only part of the picture. State taxes can significantly impact which entity saves the most.
Key State Considerations
- California: $800 minimum franchise tax for LLCs and corporations. LLC fee based on gross receipts. C-Corps pay 8.84% rate.
- Texas: No personal income tax, but franchise tax applies to certain entities based on margin.
- New York City: Does not recognize S-Corp status for city tax. S-Corps pay corporate-level tax in NYC.
- Pass-Through Entity Taxes: Many states now offer PTET elections as SALT cap workaround. Entity choice affects availability.
Multi-State Nexus
Operating in multiple states? You may have filing obligations and tax liability in each. Entity type affects how that income is allocated and taxed. Remote employees, customers, and property can all create nexus. This requires state-by-state analysis.
State tax rules vary significantly. These examples illustrate the concept. Always consult with a CPA familiar with your specific state(s) before making entity decisions.
Entity Selection Mistakes That Cost Business Owners Thousands
These mistakes are common. They’re also expensive. Avoid them.
1. Choosing Based on Liability Only
Liability protection is table stakes. Every LLC and corporation provides it. Tax efficiency is the differentiator. An LLC taxed as sole proprietor and an LLC taxed as S-Corp have the same liability protection. Very different tax bills.
2. Converting Too Late
Waiting until you’re “big enough” often means overpaying for years. If you’ve been making $80K net for three years as a sole proprietor, you’ve likely overpaid $24K+ in self-employment taxes. That money doesn’t come back.
3. Converting Too Early
S-Corp election with $30K net income means extra compliance cost for minimal savings. Payroll processing, additional tax returns, reasonable salary documentation. The overhead may exceed the tax benefit.
4. Ignoring Reasonable Salary Requirements
Zero salary or unreasonably low salary as S-Corp owner is an audit magnet. The IRS knows. The court cases are public. Pay yourself reasonably. Document how you determined the amount.
5. Not Tracking Basis
S-Corp and partnership distributions require basis tracking. Distributions exceeding basis are taxable. Fail to track basis for 10 years, then sell the business? You may owe tax on phantom gain. This is expensive to reconstruct later.
6. Choosing C-Corp for Tax Rate Alone
21% sounds great. Until you need to distribute money. Corporate tax plus dividend tax can exceed 40% combined rate. C-Corp works when you’re reinvesting. Falls apart when you need the cash personally.
Frequently Asked Questions
What business entity pays the least taxes?
It depends on your specific situation. For service businesses with $60K+ net income and few owners, S-Corporations typically minimize taxes through self-employment tax savings. For businesses reinvesting profits without regular distributions, C-Corporations may pay less. There’s no universal “best” entity. Optimal choice depends on income level, owner count, distribution needs, and growth plans.
Should I convert my LLC to an S-Corp?
Consider S-Corp election when: (1) your net income consistently exceeds $50-60K, (2) you can pay yourself a reasonable salary and still have meaningful distributions, and (3) you’re comfortable with additional compliance requirements. The math typically works when SE tax savings exceed the cost of payroll processing and additional tax preparation.
What is the reasonable salary requirement for S-Corps?
S-Corp shareholders who work in the business must pay themselves a “reasonable salary” subject to payroll taxes before taking distributions. Reasonable means comparable to what you’d pay an employee to do the same work. The IRS doesn’t specify an amount. It’s based on industry, experience, hours, and comparable wages. Too low triggers audits; too high negates S-Corp benefits.
Can I change my business entity later?
Yes, but it’s not always simple. LLC to S-Corp election is straightforward (file Form 2553). S-Corp to C-Corp is relatively easy. C-Corp to S-Corp has built-in gains considerations. Any conversion to partnership or sole prop involves liquidation. The earlier you choose correctly, the less friction later.
What’s the difference between an LLC and an S-Corp?
An LLC is a legal entity type; S-Corp is a tax election. An LLC can elect to be taxed as an S-Corp by filing Form 2553. As a legal structure, LLC offers flexibility. As a tax structure, S-Corp offers self-employment tax savings. Many businesses are LLCs that elect S-Corp taxation, getting liability protection and tax efficiency.
Do I need a CPA to choose my business entity?
While not legally required, a CPA can quantify the tax savings of different structures for your specific situation. Entity selection mistakes are expensive to fix. A CPA can also ensure proper election filing, reasonable salary determination, and ongoing compliance. The consultation cost is typically recovered many times over in tax savings.
How does QBI deduction work with different entities?
The Qualified Business Income deduction (up to 20% of qualified income) applies to sole proprietorships, partnerships, S-Corps, and some LLCs—but not C-Corps. OBBBA made QBI permanent in 2025, so this deduction is here to stay. For high earners in certain service industries (SSTBs), the deduction phases out. Entity choice affects whether you qualify and how much you can deduct. Use our QBI Calculator to estimate your deduction.
When should I form a C-Corp instead of an S-Corp?
Consider C-Corp when: (1) you’re raising venture capital or institutional investment, (2) you plan to reinvest most profits rather than distribute them, (3) you want to take advantage of QSBS exclusion for a future sale—now up to $15M under OBBBA with tiered holding periods (50% after 3 years, 75% after 4, 100% after 5), (4) you have or will have foreign shareholders, or (5) you need multiple classes of stock. For most service businesses distributing profits regularly, S-Corp is more tax-efficient.
Related Resources & Guides
Complete guide to S-Corp taxation, elections, and compliance requirements
Calculate potential savings from S-Corp election for your situation
Partnership taxation, K-1s, and multi-owner business structures
Maximize retirement contributions through S-Corp structure
Estimate your Qualified Business Income deduction by entity type
Professional S-Corp tax preparation and planning services
Form 1065 preparation and partnership tax planning
Get Your Free Entity Analysis
The right entity can save $8,000-12,000+ annually. The wrong one costs you that much. We’ll analyze your specific numbers and give you a clear recommendation.
Schedule Free Entity Analysis Try S-Corp Calculator FirstProfessional Standards: SDO CPA is a Texas-licensed CPA firm with 18+ years of experience including Big Four background (EY, KPMG). This guide provides general information about business entity taxation. Individual circumstances vary. Consult with a qualified tax professional before making entity decisions. Per Texas State Board of Public Accountancy Rule 501.82, this content reflects documented outcomes and verifiable claims. SDO CPA is a member of the American Institute of Certified Public Accountants (AICPA).