LLC, S Corp or Sole Proprietor: How Entity Choice Affects US Tax

Entity choice is the most over-discussed and least understood decision in American small business. The crucial thing to understand first is that liability protection and tax treatment are separate questions. Forming an LLC changes your legal exposure; by default it changes nothing at all about your taxes. Tax treatment follows an election, not the entity name on your certificate.

A sole proprietorship is the default for one person with no registration. Income and expenses go on Schedule C, profit flows to your personal return, and the full profit is subject to self-employment tax. There is no liability separation: a claim against the business is a claim against you. It is cheap, simple and appropriate for low-risk, modest-revenue work.

A single-member LLC is treated as a disregarded entity for federal tax, meaning you still file Schedule C and still pay self-employment tax on the whole profit. What you gain is a legal shield between business creditors and your personal assets, provided you maintain the separation properly: separate bank accounts, no commingling, contracts signed in the company name. A multi-member LLC defaults to partnership treatment, filing Form 1065 and issuing Schedule K-1s to members.

An S corporation is an election rather than a separate kind of company — an LLC or a corporation can make it. The owner becomes an employee, takes a reasonable salary through payroll subject to Social Security and Medicare tax, and receives remaining profit as a distribution that is not subject to those taxes. On $150,000 of profit with a $70,000 reasonable salary, the payroll tax saving is meaningful, which is why the structure is so widely promoted.

The savings are real but so are the costs, and they are usually understated by whoever is selling the idea. You need payroll processing with quarterly filings, a separate corporate return, possibly state franchise taxes or minimum fees, and a defensible basis for the salary figure. Setting an unreasonably low salary to maximise distributions is a known audit trigger, and the IRS has won repeatedly against owners paying themselves token wages. Most practitioners see the crossover somewhere above $80,000 to $100,000 of stable annual profit.

A C corporation pays its own tax at the flat corporate rate and then shareholders pay again on dividends — the double taxation that makes it a poor fit for most small service businesses. It becomes the right answer when you plan to raise institutional venture capital, need to issue multiple share classes or grant conventional stock options, or intend to retain substantial earnings inside the company for years.

The qualified business income deduction complicates the comparison usefully. Pass-through owners may deduct up to 20 per cent of qualified business income, subject to income thresholds, wage-and-property limits and restrictions on specified service trades such as consulting, law, accounting and health. Because S corporation wages reduce qualified business income while increasing payroll tax, the optimal salary level is a genuine calculation rather than a rule of thumb.

The sensible sequence is therefore: start as a sole proprietor or single-member LLC, keep clean books, and revisit the question once profit is consistently high and predictable. Model the S corporation election with real numbers — payroll costs, additional return preparation, state fees, the effect on your qualified business income deduction — before paying anyone to file the election. And remember that state treatment varies: a few states tax S corporations directly or impose fees that wipe out the federal saving entirely.