How Your Business Structure Affects Your U.S. Taxes

Beyond the balance sheet, your company’s business structure impacts how you pay your taxes and how much you owe.

There’s a lot of new water to navigate when you start a business. You will love some aspects, but others will give you a major headache. I’m guessing that for most, figuring out your business structure, taxes and other legalities will fall under that second category. After all, no one wants to lay awake at night worrying they’re paying more taxes than they need to.

However, when it comes to business taxes, the key is to know your business’ annual earning and spending. But beyond the balance sheet, your company’s business structure (sole proprietorship, limited liability company or corporation) impacts how you pay your taxes and how much you pay back.

Note that this reflects U.S. federal taxes and should be considered general information. As a result, it’s not a substitute for the advice of a tax expert who is familiar with your particular situation.

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Business Structure 1: The Sole Proprietorship

Solo business owners default to a sole proprietorship. This happens when you have a business but never set up an official structure with the state.

How It Affects Taxes

In terms of taxes, a sole proprietorship is not distinct from the owner. You report all your business income and losses on your personal income tax return. Consequently, the business itself doesn’t need to file a tax return.

When it’s time to file your taxes, you will report your profit and loss information on Schedule C, along with your Form 1040. Therefore, you’ll be taxed on all profits for the year, even if you decide to keep money in your business’ bank account to save for future expenses.

If you’ve never filed taxes as a sole proprietor before, be prepared to pay self-employment taxes. As a self-employed individual, you are solely responsible for your social security and Medicare contributions. The current self-employment tax rate is 15.3% (the majority of this goes toward Social Security and has an income ceiling). Check the IRS website for the most current tax rate and income ceiling, since these numbers can change between tax years.

This is the ideal structure for:

  • Someone who wants to keep things as simple as possible
  • Someone who isn’t too concerned about liability and separating themselves from the business
  • A solo entrepreneur who is not making a significant amount of profit each year
  • Someone who is just starting out and deciding if entrepreneurship is the right course

Structure 2: The LLC (Limited Liability Company)

The biggest downside with a sole proprietorship is that the owner and business are not separate. In terms of liability, if someone sues a sole proprietorship, they are suing the owner personally and their personal assets are on the hook.

An LLC puts some separation between you and your business. As a result, if you’re sued or can’t pay business debts, your personal obligations may be protected. What’s nice about an LLC is that it offers liability protection and keeps administrative requirements to a minimum. Consequently, an LLC has significantly less paperwork and formalities than a corporation.

How It Affects Taxes

By default, an LLC is considered a pass-through entity, similar to a sole proprietorship. The owners (members) must pay taxes on their share of the profits. And that’s true whether or not the money stays in the business. So, let’s say you’re the sole owner of an LLC. The business makes $80,000 in profit for the year, but you want to keep $40,000 in your business bank account to prepare for a big expense next year. With an LLC structure, you have to pay taxes on the entire $80,000 on your personal tax return.

If you’re actively working in the business (e.g., you have a graphic design business and you personally do graphic design or account management work), then you will need to pay self-employment taxes on the business’ profit.

S Corporation Advantages

An LLC can elect S corporation tax treatment with the IRS. An S corporation has pass-through tax treatment like a sole proprietorship or LLC, therefore you will report the business’ profits on your personal tax return.

But, there’s one key difference. With an S corporation, you have the flexibility to separate the business’ income into two buckets: your salary and distributions. Only your salary is subject to FICA tax for social security and Medicare—the distributions are not. This allows you to take a chunk of money that’s not subject to FICA and self-employment tax. However, be cautious with this strategy. It’s an IRS requirement to pay yourself a reasonable salary for the job (and they will check!). You can’t get away with a $10,000 annual salary and $50,000 in distributions.

This is the ideal structure for:

  • Someone who likes the security of separating their personal assets from business liabilities
  • Someone who prefers minimal formalities and paperwork
  • Entrepreneurs who anticipate a loss in the first year or two and want to report this loss on their personal tax return
  • A solo entrepreneur/working owner who is concerned about reducing self-employment taxes (needs to elect S corporation status)

Structure 3: The Corporation

Like an LLC, a corporation separates the business owner from the business, helping to protect personal assets from liabilities of the company. A corporation is a separate legal entity: It can sue and be sued, it has its own credit history and rating, and it’s responsible for paying its own taxes. However, unlike an LLC, company profits and losses are not passed along to the business owners; the corporation itself pays taxes on its profits.

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How It Affects Taxes

In some cases, this tax structure leads to “double taxation.” This means the government taxes a company on its profits, and when the owners take those profits out, they will need to report the distribution on their personal tax return. Certainly, double taxation is costly for some small business owners accustomed to taking profits out of the business.

However, a corporation can elect S corporation tax treatment to be treated as a pass-through entity. Then, profits and losses are passed along to the owners (shareholders).

Should You Elect S Corporation Status?

That said, in which cases does it make sense to keep your business structured as a regular corporation (and not elect S corporation status)? Simply if you want to keep some money inside the business. C corporation owners are taxed only on the actual amount they receive as distributions. By working with a tax adviser, you can allocate your business’ profits in a way to take advantage of lower income tax brackets. You won’t be taxed personally if the money remains in the business (and the corporate tax rate may be lower than your individual rate).

This is the ideal structure for:

  • Someone who likes the security of separating their personal assets from business liabilities
  • Someone who doesn’t mind added corporate formalities and paperwork
  • Entrepreneurs who want the flexibility of keeping money inside the business, and may be able to take advantage of lower corporate tax rates
  • A solo entrepreneur/working owner who is concerned about reducing self-employment taxes (needs to elect S corporation status)

When it comes to choosing a structure, there’s no single correct answer that works for every business. You need to think about your financial situation and future plans to determine the optimal structure for your needs. As we approach the end of the year, this is a good time to get your business structure squared away. Then, you can begin the new tax year fresh with your new entity.

This is an archived post from the FreshBooks Blog and was originally published in November 2016.

about the author

Freelance Contributor Nellie Akalp is a passionate entrepreneur, small business expert, professional speaker, author, and mother of four. She is the Founder and CEO of, an online legal document filing service and recognized Inc.5000 company. At CorpNet, Nellie assists entrepreneurs across all 50 states to start a business, incorporate, form an LLC, and apply for trademarks. She also offers free business compliance tools for any entrepreneur to utilize. Connect with Nellie on LinkedIn.