Choosing the Right Business Entity: How It Impacts Your Taxes

Have you ever wondered why some businesses pay less tax than others, even if they make more money? The secret often lies in the type of business structure they choose. 

Starting a business is exciting and sometimes the process of starting can feel like you’re drinking water from a firehose with a laundry list of tasks that need to be done yesterday!

But your selection of your business entity type can impact your business in so many ways and you need to plan carefully—especially when it comes to taxes. 

One of the most important decisions you'll make as a business owner is picking the right kind of business structure. The type of entity that you choose can have a big impact on how much you pay in taxes, how much you are personally responsible for, and impact your long term business growth. 

From Sole Proprietorships to C-Corporations, each type has its own pros and cons. 

As you read on, we’ll introduce different business types and explain how your choice affects taxes. 

This is the first article in a series to help you choose the right business type to save on taxes.

Why Entity Selection Matters for Taxes

The business type you choose will decide how much tax you will pay and when you have to pay it. Some types are taxed directly, while others pass their income through to the owners' personal tax returns. 

Picking the right type could help you save thousands of dollars every year by using tax rules that work best for your business.

Imagine Maria, who runs a small consulting business. By changing her business from a Sole Proprietorship to an S-Corp, she was able to save $10,000 in self-employment taxes last year. 

Understanding the nuances and differences of the various legal structures can help you avoid surprises at tax time and set your business up for success.

Which Business Entity is Best for You?

Let’s look at the most common types of businesses entity types and how they affect your taxes:

1. Sole Proprietorship

A Sole Proprietorship is the simplest type of business. It’s owned by one person, and there is no legal separation between the owner and the business.

• Taxation: All the profits are reported on the owner's personal tax return, and the owner has to pay self-employment taxes (15.3% in 2024).
• Advantages: Easy to set up, not much paperwork, and simple tax filing.
• Disadvantages: No personal asset protection, and owners must pay self-employment tax on all profits.
• Best For: Freelancers, consultants, and small home-based businesses.
• Pro Tip: If you’re thinking about growing your Sole Proprietorship, consider switching to an LLC for extra protection.

2. Partnership

A Partnership is a business owned by two or more people who agree to share the profits, losses, and responsibilities.

• Taxation: Partnerships are pass-through entities, which means the business itself does not pay income tax. Instead, profits and losses are passed through to the partners, who report them on their personal tax returns.
• Advantages: Flexible profit-sharing and simple pass-through taxation.
• Disadvantages: Partners are personally responsible for business debts, and profits are subject to self-employment tax.
• Best For: Two or more people or businesses working together.
• Pro Tip: Create a partnership agreement early on to avoid any misunderstandings about profit-sharing.

3. Limited Liability Company (LLC)

An LLC is a flexible type of business that offers protection to its owners (called members). LLCs can be taxed like a Sole Proprietorship, Partnership, or Corporation, depending on how they file with the IRS.

• Taxation: Single-member LLCs are taxed like Sole Proprietorships, while multi-member LLCs are taxed like Partnerships by default. However, LLCs can choose to be taxed as an S-Corp or C-Corp.
• Advantages: Offers liability protection and flexibility in how it’s taxed.
• Disadvantages: Can be more complex to manage if taxed as a corporation.
• Best For: Businesses looking for flexibility and liability protection.
• Pro Tip: Elect S-Corp status for your LLC to save on self-employment taxes.

4. S-Corporation (S-Corp)

An S-Corp is a type of corporation that passes its income, losses, and deductions to its shareholders to avoid double taxation.

• Taxation: Income goes to the shareholders and is taxed at their personal rates. S-Corp owners can split income between a salary (which has payroll taxes) and distributions (which don’t have payroll taxes).
• Advantages: Can save on self-employment taxes by paying a reasonable salary and distributing extra profits.
• Disadvantages: Requires stricter rules, including corporate tax returns and payroll for shareholders.
• Best For: Small to medium businesses with active owners who want to save on self-employment taxes.
• Pro Tip: Pay yourself a 'reasonable salary' as an S-Corp owner to avoid trouble with the IRS.

5. C-Corporation (C-Corp)

A C-Corp is a separate legal entity from its owners. It can issue stock and have an unlimited number of shareholders, which makes it great for raising money.

• Taxation: C-Corps are taxed twice—once at the corporate level (21% in 2024) and then again on dividends paid to shareholders.
• Advantages: Can offer more benefits to employees and has no limits on growth.
• Disadvantages: Double taxation and more complicated paperwork.
• Best For: Larger businesses or those wanting to attract investors.
• Pro Tip: If you want to attract investors, a C-Corp is the best choice since you can issue stock.

How to Choose the Right Business Entity: Key Factors

When deciding on the best entity for your business, think about these factors:

• Size and Nature of Your Business: Smaller businesses usually benefit from pass-through taxation to avoid double taxation. Larger businesses that want to raise money might need a C-Corp.
• Future Growth: If you plan to grow quickly or get outside investors, a C-Corp might be the best choice because you can issue stock.
• Liability Protection: LLCs, S-Corps, and C-Corps offer protection to keep your personal assets safe from business debts.
• Tax Savings: S-Corps can help you save on self-employment taxes by paying a reasonable salary and taking profits as distributions.
• Complexity: Sole Proprietorships and Partnerships are easy to manage, while LLCs and Corporations need more paperwork and follow more rules.
• Niche Restrictions: Depending on your business type and niche, there may be restrictions imposed by your State. For example, in California the State Contractors License Board does not allow businesses to form an LLC. They want a C-Corporation formed and then the business owners can make the S-Corporation election. Or in Texas, the Texas Real Esatate Commission requires that you be a Broker to be able to form a Corporation. It’s wise to check with an attorney that regularly handles your business type for entity formations to ensure that headaches are avoided down the road.

The Tax Implications of Pass-Through vs. Corporate Entities

The biggest tax difference between business types is whether they are taxed as pass-through entities or corporate entities:

• Pass-Through Entities: Income flows directly to the owners' personal tax returns. These include Sole Proprietorships, Partnerships, LLCs (by default), and S-Corps. Pass-through entities avoid double taxation, which is great for smaller businesses.
• Corporate Entities: C-Corps pay taxes as a company first, then shareholders pay taxes on dividends. This double taxation can make C-Corps less attractive for small businesses unless they want to grow fast or raise lots of money.

NOTE: The pass through entities mentioned above and the avoidance of double taxation is true at the Federal level but there may be a State tax imposed on the Corporation or entity in addition to any State income tax. 

Conclusion

Choosing the right business type can have a big effect on your taxes and how successful your business will be. By understanding the differences between each type, you can make the best decision to meet your business goals and save on taxes.

Want to make sure you’re saving as much as possible on your taxes? 

We address your legal structure as part of our CUSTOM Tax Strategy Roadmap creation. Reach out to us at MakeTaxesFair.com/Get-My-Roadmap and let us help you get optimized.

In our next article, we’ll take a deeper dive into Sole Proprietorships and Single-Member LLCs, looking at their pros and cons and how to save the most on taxes.