Running a business means choosing a legal structure that keeps Uncle Sam happy without draining your bank account. While paperwork and liability often dominate the conversation, taxes can quietly make or break your bottom line. Below, we unpack how income flows—and how it’s taxed—under three common setups so you can pick the path that best protects both your profits and your peace of mind.
Sole Proprietorship: Simple but Self-Employment Heavy
In a sole proprietorship, the business and the owner are one and the same for tax purposes, so every dollar of profit slides straight onto Schedule C of your personal Form 1040. The good news is zero entity-level filing and no separate return to prepare. The downside shows up at tax time: you’ll pay ordinary income tax and the full 15.3 percent self-employment tax on net earnings.
You can write off business expenses—think home-office costs, supplies, mileage—but retirement planning is limited to IRA or solo 401(k) contributions, and high earnings can trigger the 0.9 percent Additional Medicare Tax surcharge.
Limited Liability Company: Pass-Through Flexibility
An LLC defaults to pass-through taxation—single-member LLCs file like sole proprietors, while multi-member LLCs use Form 1065 and issue each owner a Schedule K-1. Profits still avoid entity-level income tax, but members may reduce self-employment hits by electing S-corporation status and paying themselves a “reasonable salary.”
Even without that election, LLCs shine in their ability to distribute profits according to an operating agreement rather than strict ownership percentages. You’ll also enjoy broader retirement plan choices and the potential to deduct health insurance premiums, yet state LLC fees—and sometimes franchise taxes—can nibble away at savings.
S Corporation: Salary Split and Payroll-Tax Relief
Opting for S-corporation treatment under Subchapter S of the Internal Revenue Code keeps pass-through benefits but adds one powerful twist: only the wages you pay yourself are subject to payroll tax, while the remaining profit distributions dodge self-employment tax completely. File Form 1120-S annually, issue yourself a W-2, and send Schedule K-1s to shareholders.
This structure does demand diligent bookkeeping—skimping on a “reasonable salary” can raise IRS eyebrows—and you’re capped at 100 shareholders, all U.S. citizens or residents. Still, many small-business owners find the payroll-tax savings outweigh the extra paperwork and stricter ownership rules.
C Corporation: Double Tax with Strategic Upside
A C corporation is its own taxpayer, filing Form 1120 and paying the current flat corporate income rate on profits before any dividends reach shareholders. Those dividends then appear on personal returns, creating the infamous “double taxation.” Yet corporations can retain earnings, offer expansive fringe benefits, and issue multiple share classes to lure investors.
If growth plans involve reinvesting profits, spreading equity widely, or eventually going public, the C-corp route may justify its heavier compliance load—especially when careful tax optimization strategies offset some of that double-tax bite.
Conclusion
No single structure fits every entrepreneur. Sole proprietorships keep things lean yet pile on self-employment tax, LLCs marry flexibility with liability protection, S corps trade bookkeeping for payroll savings, and C corps offer scaling power at the cost of two tax layers.
Weigh your profit expectations, administrative tolerance, and growth horizon, then consult a qualified advisor before setting those signatures in ink. A thoughtful choice today can spare you costly surprises when tax season rolls around.
