⚖️ Entity Selection Framework
Choose based on liability needs, tax preferences, and growth plans. Sole proprietorship for simple service businesses, LLC for asset protection with flexibility, S-Corp for self-employment tax savings, C-Corp for investor funding and scaling.
Your Business Structure Affects Everything
Your business entity choice impacts how much you pay in taxes, your personal liability for business debts, how you can raise money, and even your credibility with customers and vendors. The wrong choice can cost thousands in extra taxes or expose you to personal lawsuits.
This guide breaks down each entity type with real examples, tax implications, and decision frameworks to help you choose the structure that fits your business goals and situation.
Business Entity Comparison Overview
Each business structure balances liability protection, tax efficiency, and operational complexity differently.
| Entity Type | Liability Protection | Tax Treatment | Setup Cost | Best For |
|---|---|---|---|---|
| Sole Proprietorship | None | Personal tax return | $0-50 | Simple service businesses |
| Single-Member LLC | Strong | Personal tax return | $100-500 | Solo entrepreneurs |
| Multi-Member LLC | Strong | Partnership return | $100-500 | Partnerships, flexible ownership |
| S-Corporation | Strong | Pass-through + W2 | $500-1,500 | High-income service providers |
| C-Corporation | Strongest | Double taxation | $1,000-3,000 | Investor funding, scaling |
Sole Proprietorship: Simplest but Riskiest
Default structure for unincorporated businesses—easy to start but offers no liability protection.
Sole Proprietorship Characteristics
Advantages
- • No formation paperwork or fees
- • Simple tax filing (Schedule C)
- • Complete control and flexibility
- • No separate bank account required
- • Easy to dissolve
Disadvantages
- • Personal liability for all business debts
- • Self-employment tax on all profits
- • Limited credibility with vendors/customers
- • Cannot raise investor capital
- • Difficult to sell or transfer business
⚠️ Personal Liability Risk
As a sole proprietor, your personal assets (home, car, savings) can be seized to pay business debts or lawsuit judgments. This includes accidents, product liability, contract disputes, or employee issues.
Example: A client slips at your home office and sues for $200,000. Your homeowners insurance might not cover business activities, putting your house at risk.
Good Fit For Sole Proprietorship
- Very low liability businesses: Freelance writing, consulting, tutoring
- Testing business ideas: Start simple before committing to entity formation
- Very small revenue: Under $10,000 annually
- No employees: Just you, no contractors or staff
- No physical location: Service-based, no customer visits
Limited Liability Company (LLC): Flexibility with Protection
Most popular choice for small businesses—combines liability protection with tax flexibility.
LLC Key Features
Liability Protection
Members' personal assets generally protected from business debts and lawsuits (with exceptions for personal guarantees and negligence)
Tax Flexibility
Can elect different tax treatments: sole proprietorship (single-member), partnership (multi-member), S-Corp, or C-Corp
Ownership Flexibility
Unlimited members, different classes of ownership, profit/loss allocations that don't match ownership percentages
Management Structure
Member-managed (owners run day-to-day) or manager-managed (hired managers), flexible operating agreement terms
LLC Formation Process
📋 LLC Formation Checklist
- ☐ Choose available business name
- ☐ File Articles of Organization with state
- ☐ Create Operating Agreement (even single-member)
- ☐ Obtain EIN from IRS
- ☐ Open business bank account
- ☐ Get required business licenses/permits
- ☐ Set up accounting system
- ☐ Consider professional liability insurance
S-Corporation: Tax Savings for High Earners
Tax election that can save self-employment taxes for profitable businesses.
S-Corp Tax Advantage
Self-Employment Tax Savings
LLC/Sole Prop: Pay 15.3% self-employment tax on ALL profit
S-Corp: Pay payroll taxes only on reasonable salary, not on distributions
Example: $100k profit
LLC: $100k × 15.3% = $15,300 SE tax
S-Corp: $60k salary × 15.3% = $9,180 payroll tax
Savings: $6,120 annually
S-Corp Requirements and Restrictions
- Reasonable salary required: Must pay yourself W-2 wages for services performed
- 100 shareholders maximum: All must be US citizens/residents
- One class of stock: No preferred shares or different voting rights
- Calendar year: Generally required unless business purpose for different year
- Payroll compliance: Quarterly reports, annual W-2s, unemployment taxes
⚡ Reasonable Salary Rule
IRS requires S-Corp owners who work in the business to pay themselves a "reasonable salary" for services performed. You cannot just take distributions to avoid payroll taxes entirely.
Rule of thumb: 60-70% of profit as salary, remaining as distributions. IRS looks at comparable wages for similar roles in your industry and location.
C-Corporation: Built for Growth and Investment
Traditional corporate structure with strongest liability protection and investment capabilities.
C-Corp Advantages for Growth
Investment-Friendly
- • Multiple stock classes (common, preferred)
- • Employee stock options and plans
- • Venture capital and institutional investors
- • No ownership restrictions
- • Perpetual existence
Tax Benefits
- • Lower initial tax rates (21% federal)
- • Retain earnings for growth
- • Deduct 100% of health insurance
- • Section 1202 qualified small business stock
- • Deduct losses against other income
C-Corp Double Taxation Challenge
Double Taxation Reality
C-Corp profits are taxed at the corporate level (21% federal), then again when distributed as dividends to shareholders (up to 20% capital gains rate). This creates an effective tax rate of up to 37% on distributed profits.
Corporate profit: $100,000
Corporate tax: $21,000 (21%)
Dividend distribution: $79,000
Shareholder tax: $15,800 (20%)
Total tax: $36,800 (36.8%)
Decision Framework: Which Entity to Choose
Use these decision trees to narrow down your best options.
Primary Decision Factors
1. Liability Exposure
High risk (customers, employees, products) = LLC minimum. Professional services = consider professional liability insurance regardless of entity.
2. Tax Optimization
Profit over $60k = consider S-Corp election. Need to retain earnings = C-Corp. Want flexible distributions = LLC.
3. Growth and Investment Plans
Seeking investors = C-Corp. Partner with others = LLC or S-Corp. Solo operation = LLC or sole prop.
4. Administrative Tolerance
Want simplicity = sole prop or LLC. Can handle payroll = S-Corp or C-Corp. Need maximum formality = C-Corp.