When you’re launching a business, tax structure might seem like a later problem. You’re thinking logos, websites, clients, sales – not IRS forms. But here’s the truth: how you set up your business legally can change how much you owe in taxes – dramatically.
Business entity type isn’t just a legal technicality. It’s a tax identity. And if you pick the wrong one – or never pick at all – you could end up giving the IRS more than your fair share.
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Sole Proprietorship: Simple But Pricey
By default, if you start working for yourself and don’t register a business entity, you’re a sole proprietor. It’s easy – no paperwork, no special forms – but that convenience comes at a cost:
- You pay self-employment tax on all your net earnings – 15.3% on top of regular income tax.
- No option to separate personal and business income – everything flows onto your 1040 via a Schedule C.
- No tax planning flexibility. What you earn is what you pay on, period.
It’s fine for a hobby that earns $2,000 a year. Not so great for a growing freelance business or side hustle that’s becoming real income.
LLC: Flexibility in Disguise
An LLC (Limited Liability Company) doesn’t change how you’re taxed by default. You’re still taxed like a sole proprietor if you’re the only owner. But here’s where it gets interesting: an LLC gives you tax options.
With an LLC, you can:
- Remain taxed as a sole proprietor (simple, but still pay self-employment tax).
- Elect to be taxed as an S Corporation to potentially reduce self-employment taxes.
The LLC gives you the legal structure and the flexibility to choose the tax identity that saves you money.
S Corporation: The Tax Optimization Tool
Here’s where smart business owners really start shaving down their tax bill. When your profits cross a certain threshold (often around $40,000+), electing to have your LLC taxed as an S Corporation can help you:
- Split income between salary and dividends. Only your salary is subject to self-employment tax.
- Potentially save thousands in taxes each year if done correctly.
But there’s a catch. With great tax savings comes… paperwork. You’ll need:
- To run payroll (even if it’s just for yourself)
- To file an 1120-S return for the business
- To keep tighter books and make quarterly estimated payments
It’s more complex, but the savings can be substantial once your business is making real money.
Partnerships and Multi-Member LLCs
If you and a partner start a business together without forming an entity, you’re in a general partnership by default – a risky move legally and a headache tax-wise.
Forming a multi-member LLC gives you a formal business structure and automatically gets taxed as a partnership unless you elect something else.
- Each partner receives a Schedule K-1 showing their share of income, deductions, and credits.
- Partnerships must file an informational tax return (Form 1065), even if no tax is owed.
It’s more paperwork, but far better than staying informal and dealing with IRS confusion or partner disputes later.
Corporation (C Corp): Usually Overkill for Solos
Some folks hear “C Corporation” and think “that’s what big businesses use – I want to sound professional.” But forming a C Corp means:
- Paying corporate taxes at the entity level
- Then paying personal taxes on dividends (double taxation)
- Following strict rules and corporate formalities
Unless you’re planning to raise outside capital or reinvest profits heavily in the business, a C Corp is probably not your best bet starting out.
Real Tax Difference: An Example
Let’s say you make $80,000 net profit as a sole proprietor. You’ll owe:
- ~$12,240 in self-employment tax (15.3%)
- Plus income tax, depending on your bracket
Now imagine that same income under an S Corp structure. You pay yourself a “reasonable salary” of $40,000, and take the other $40,000 as a distribution:
- Only the $40,000 salary is subject to self-employment tax (~$6,120)
- Distributions are still taxed, but not as self-employment income
You just saved over $6,000 in self-employment taxes – enough to cover an LLC setup, accountant, and then some.
LLC: The Gateway to Smarter Taxes
Here’s why forming an LLC is a smart first move:
- You get liability protection
- You get to choose how you’re taxed
- You signal professionalism to clients and vendors
And when your business starts earning more, you can switch your LLC to S Corp taxation without changing your legal setup. Flexibility now, and smarter taxes later.
The Bottom Line
Choosing your business entity isn’t just about compliance – it’s a decision that affects every dollar you owe to the IRS. Defaulting to sole proprietor might be easy, but it’s not cheap.
Structure your business thoughtfully. With an LLC in place, you can evolve, adapt, and minimize your tax burden as you grow. Waiting costs money. Planning pays.
