Complete Guide to Business Structure and Tax Obligations: Choose the Structure That Saves Thousands

Your business structure determines how much tax you pay, which forms you file, and what deductions you can take. Choose wrong, and you're leaving thousands on the table every year. Choose right, and you can legally minimize your tax burden while protecting your assets.

This comprehensive guide will walk you through every business structure, how each one is taxed, which forms you need to file, and how to choose the structure that saves you the most money. We're talking about decisions that can save you $10,000, $20,000, or even $50,000+ annually.

Sole Proprietorship: The Simplest Structure

A sole proprietorship is the default structure you're in business, you're a sole proprietor. No formation required, no separate tax return. You report business income and expenses on Schedule C attached to your personal tax return.

Tax Treatment

All business income flows directly to your personal return. You pay income tax and self-employment tax (15.3%) on all net earnings. There's no entity level taxation, but there's also no liability protection.

When It Makes Sense

Sole proprietorships work for low risk businesses with low income. If you're making under $50,000 and don't need liability protection, it might be fine. But once you hit $75,000+, an S-Corp usually saves money.

LLC: Liability Protection with Flexibility

An LLC (Limited Liability Company) provides liability protection while maintaining tax flexibility. By default, single-member LLCs are taxed as sole proprietorships, and multi-member LLCs are taxed as partnerships. But you can elect to be taxed as an S-Corp or C-Corp.

Tax Treatment

By default, LLCs are pass through entities. Income flows to members' personal returns via Schedule K-1 (multi-member) or Schedule C (single-member). Members pay self-employment tax on all earnings.

The S-Corp Election Loophole

Here's where it gets interesting: LLCs can elect S-Corp status. This lets you avoid self-employment tax on distributions while maintaining the legal protection of an LLC. It's the best of both worlds.

S-Corporation: The Self-Employment Tax Loophole

An S-Corporation is a tax election, not a legal structure. You form an LLC or corporation, then elect S-Corp status. This lets you avoid self-employment tax on distributions while maintaining pass through taxation.

Tax Treatment

S-Corps pass income to shareholders' personal returns via Schedule K-1. Shareholders pay themselves "reasonable compensation" as W-2 employees (subject to payroll taxes), then take the rest as distributions (not subject to self-employment tax).

The Savings

For a business making $200,000 with $100,000 reasonable salary, you save 15.3% on $100,000 = $15,300 annually. The savings increase as your income grows.

C-Corporation: Double Taxation but Retention Benefits

A C-Corporation faces double taxation: the corporation pays tax at 21%, then shareholders pay tax on dividends. But C-Corps can retain earnings in the business without shareholders paying tax until distributions.

Tax Treatment

C-Corps pay corporate tax at 21% on profits. When profits are distributed as dividends, shareholders pay tax on the dividends. This is "double taxation," but it can be beneficial if you want to retain earnings.

When It Makes Sense

C-Corps work if you want to retain earnings in the business, plan to raise capital, or want to offer employee stock options. But for most small businesses, pass-through entities are better.

Which Forms You Need to File

Each structure has different filing requirements:

Sole Proprietorship

Schedule C attached to Form 1040. That's it. Simple, but you pay self-employment tax on everything.

LLC (Default)

Single-member: Schedule C. Multi-member: Form 1065 (partnership return) with Schedule K-1s to members.

S-Corp

Form 1120-S (information return) with Schedule K-1s to shareholders. Plus payroll returns (Form 941) for reasonable salaries.

C-Corp

Form 1120 (corporate tax return). The corporation pays tax, then shareholders pay tax on distributions.

How to Choose the Right Structure

The "best" structure depends on your income, goals, and situation. Here's a framework:

Income Under $50,000

Sole proprietorship or LLC might be fine. The compliance costs of an S-Corp probably aren't worth it.

Income $50,000-$200,000

S-Corp usually makes sense. The self-employment tax savings outweigh the compliance costs.

Income Over $200,000

S-Corp almost always makes sense. The savings are substantial.

Want to Retain Earnings

C-Corp might make sense. You can retain earnings in the business without shareholders paying tax.

Want to Raise Capital

C-Corp or LLC. C-Corps can issue stock. LLCs can issue membership interests.

State Tax Considerations

Some states tax S-Corps differently than LLCs. Some states have franchise taxes. Some states have no income tax. Your state matters.

California has an $800 minimum franchise tax for LLCs and S-Corps. That's $800 you're paying regardless of income. Factor this into your decision.

Changing Structures: The Tax Implications

You can change structures later, but there are tax implications. Switching from C-Corp to S-Corp might trigger built in gains taxes. Switching from S-Corp to C-Corp might trigger gains on appreciated assets.

It's better to choose right the first time. But if you need to change, consult with a tax professional to minimize the tax impact.

Your business structure determines how much tax you pay, which forms you file, and what deductions you can take. Choose wrong, and you're leaving thousands on the table every year. Choose right, and you can legally minimize your tax burden while protecting your assets. It's one of the most important decisions you'll make.

Sources: IRS: Business Structures