Which Business Entity Should You Choose? What the Tax Code Actually Says

Most people choose their business entity based on what their attorney recommends, what their neighbor used, or what came up first in a Google search. Very few choose it based on a deliberate tax analysis.

That's not a criticism. The entity choice conversation at formation usually focuses on liability protection and legal structure, both of which matter. But the tax implications are just as significant, and they don't usually come up until it's time to file.

By then, the decisions that affected your first year or two are already made. This post walks through the main entity options for small businesses, what each one means for taxes, and the situations where it makes sense to revisit the choice you made at the start.

The Default: LLC

An LLC (limited liability company) is the most common small business structure, and for good reason. It's straightforward to form, provides personal liability protection, and doesn't require much ongoing maintenance. California has an $800 annual minimum franchise tax and additional fees for LLCs with higher gross income, but the structural simplicity still makes it the go-to starting point for most founders.

By default, a single-member LLC is taxed as a sole proprietorship for federal purposes. A multi-member LLC is taxed as a partnership. Either way, the business itself doesn't pay federal income tax. The net income flows through to the owner's personal return, where it gets taxed at your individual rate.

The issue is self-employment tax. As a sole proprietor or general partner, you pay SE tax on all net business income: 15.3% on the first $168,600 (the 2024 Social Security wage base) and 2.9% above that. For a business netting $100,000, you're looking at roughly $14,130 in SE tax before income tax. That's a real number. It's also where entity structure planning starts to matter.

The S-Corporation Election

An LLC or C-Corp can elect to be taxed as an S-Corporation by filing Form 2553 with the IRS. For many small businesses earning consistent profit, this election is one of the most effective tax-reduction strategies available.

Here's the mechanism: in an S-Corp, you pay yourself a reasonable salary. That salary is subject to payroll taxes. But any remaining profit above your salary distributes to you as an owner distribution, which is not subject to SE or payroll tax.

If your business nets $150,000 and you pay yourself a reasonable salary of $85,000, roughly $65,000 distributes without SE tax. At 15.3%, that's nearly $10,000 in annual tax savings. The savings come at a cost: you need to run actual payroll, file additional returns (Form 1120-S), and pay your accountant for the increased complexity. But for many businesses, the net savings are well above those costs.

The S-Corp election generally starts to make financial sense when net business income is consistently above $60,000 to $80,000, depending on your state. Below that threshold, the administrative overhead tends to eat most of the savings.

In California, the calculation is a bit different. S-Corps here pay an additional 1.5% franchise tax on net income, with an $800 minimum. That reduces the savings relative to other states. The election can still make sense in California, but the income threshold where it starts to pencil out is higher, typically around $80,000 to $100,000 in net income.

There's also the timing issue. S-Corp elections for the current tax year generally need to be filed within the first 75 days of the year, or within 75 days of entity formation for a new business. Miss that window and you're waiting at least a year. This is one of the most common reasons people end up in a suboptimal structure: the conversation happened too late to act on it.

The C-Corporation

The C-Corp pays corporate income tax at the entity level before any money reaches the owner. The current federal rate is a flat 21%. When profits are distributed as dividends, they get taxed again at the shareholder level.

For most small business owners, that's a worse outcome than a pass-through structure. You're effectively paying tax twice on the same earnings.

There are cases where a C-Corp makes sense. If you're planning to raise venture capital, a C-Corp is the standard structure investors expect. If you're retaining significant profit inside the business for reinvestment and don't need it personally, the 21% corporate rate can be lower than your individual marginal rate. For certain professional service businesses, a C-Corp provides specific structural advantages.

But 'my attorney set it up as a C-Corp' is not itself a reason to be a C-Corp. I've reviewed small businesses taxed as C-Corps where the owners were paying double taxation on distributions, with no offsetting benefit. That's an expensive structure to be in without understanding why.

When to Review Your Entity Structure

A few situations make a review worth doing.

Your income has grown significantly. If your business was netting $40,000 when you formed it and is now netting $120,000, the structure that made sense three years ago may not be the most efficient one today. The S-Corp math changes substantially as income grows.

You're planning to bring on partners or investors. Changes in ownership have tax implications that vary by entity type. Planning before the change is far easier than unwinding a structure after.

You've added significant assets. Businesses that own real estate, equipment, or intellectual property have different structural considerations than pure service businesses.

You're planning an exit. How you're taxed when you sell or transfer your business depends heavily on what type of entity it is and how it's structured.

The election timing matters. If you're considering an S-Corp election for the current year, that window closes quickly. The earlier this conversation happens, the more options you have.

What to Do Next

Entity structure isn't a set-it-and-forget-it decision. The structure that made sense when you were starting out may not be the most efficient one now that your revenue has stabilized and grown.

A tax analysis doesn't have to be complicated. The basic question is: given your current net income, your state, your payroll situation, and your plans for the business, what's the most efficient way to be structured? That analysis has a dollar answer attached to it. Sometimes the answer is 'stay where you are.' Sometimes it's not.

If you formed your entity more than two years ago and haven't had a CPA look at whether it still makes sense, it's worth the conversation.