Choosing the right business structure for taxes is one of the most critical decisions for new business owners. The structure you select affects not only your liability and management flexibility but also your tax obligations. As your business grows, the structure that served you well in the early stages might start costing you more in taxes than it should.
Let’s break down the main entity types—sole proprietorships, LLCs, S corporations, and C corporations—and compare their tax implications. We’ll also explain when it may be time to restructure your business for better tax efficiency.
Sole Proprietorship: Simple, But Limited
Best For: Freelancers, consultants, or one-person operations just starting out.
Tax Treatment:
- Income is reported on the owner’s personal tax return using Schedule C.
- Subject to self-employment tax (15.3% as of 2024) on net income.
- No separation between personal and business income.
Pros:
- Easy and inexpensive to set up.
- No separate corporate tax filings.
Cons:
- Higher effective tax rates due to self-employment tax.
- No ability to retain earnings within the business.
When to Consider Switching: Once your profits exceed around $40,000–$50,000 annually, forming an LLC or S-Corp may reduce your tax burden.
Limited Liability Company (LLC): Flexibility With Pass-Through Taxation
Best For: Small businesses that want liability protection and flexible tax options.
Tax Treatment:
- By default, taxed as a sole proprietorship (single-member) or partnership (multi-member).
- Can elect to be taxed as an S-Corp or C-Corp.
Pros:
- Limited liability for owners.
- Pass-through taxation avoids corporate taxes.
- Eligible for the Qualified Business Income (QBI) deduction under IRS Section 199A (up to 20%).
Cons:
- Still subject to self-employment taxes unless taxed as an S-Corp.
- Annual filing and renewal fees in some states.
When to Consider S-Corp Election: If you’re consistently earning over $75,000 in profit, electing S-Corp status may allow you to take part of the income as a distribution rather than salary—reducing self-employment tax.
S Corporation (S-Corp): Strategic Tax Savings for Growing Businesses
Best For: Established businesses generating consistent profits and able to pay a reasonable salary.
Tax Treatment:
- Pass-through entity—no federal corporate income tax.
- Owners pay themselves a reasonable salary subject to payroll taxes.
- Remaining profits can be distributed as dividends—not subject to self-employment tax.
Pros:
- Significant tax savings on self-employment taxes.
- Still qualifies for QBI deduction.
- Limited liability protection.
Cons:
- More IRS scrutiny over “reasonable salary.”
- Requires payroll setup and regular filings (e.g., Form 1120S).
- Limited to 100 shareholders, all of whom must be U.S. citizens or residents.
When to Consider Switching: When your business starts generating $80,000+ in annual profit and you can afford to run payroll and meet IRS requirements.
C Corporation (C-Corp): Best for Larger or High-Growth Companies
Best For: Startups planning to raise capital, reinvest profits, or go public.
Tax Treatment:
- Separate taxable entity—files its own tax return (Form 1120).
- Profits taxed at a flat corporate tax rate (21%).
- Double taxation applies: once at the corporate level and again when dividends are distributed to shareholders.
Pros:
- Ideal for attracting investors or issuing stock.
- Can retain profits in the business for future growth.
- Deducts a wider range of benefits (e.g., health insurance, retirement plans).
Cons:
- Subject to double taxation unless profits are reinvested.
- More complex compliance and reporting.
When to Consider Switching: When raising external funding or planning for long-term growth, a C-Corp structure may provide more flexibility and credibility.
When to Reevaluate Your Business Structure
As your business evolves, so should your entity structure. Here are signs it may be time to switch:
- You’re earning consistent profits over $70K and want to reduce self-employment tax.
- You’re planning to hire employees or set up a retirement plan.
- You need to raise capital or bring in outside investors.
- You’re expanding across state lines or internationally.
Consult a Tax Professional Like Kawatra CPA to Explore Your Options
The best business structure for taxes depends on your income, goals, and risk tolerance. While sole proprietorships and LLCs are popular for their simplicity, S-Corps and C-Corps can provide long-term tax savings if managed correctly. Consult a CPA or tax advisor to evaluate your specific situation and structure your business for financial efficiency.