Business Structures

Sole Proprietorship: The Default Starting Point

Every business begins as a sole proprietorship by default—it's the simplest structure requiring no formal registration beyond necessary licenses and permits. When you start earning money without establishing another entity, the IRS automatically classifies you as a sole proprietor. This structure works well for testing business ideas with minimal legal risk, but it comes with significant limitations as you scale.

The U.S. Small Business Administration reports that 73% of all businesses are sole proprietorships, largely because of their simplicity. You report business income on Schedule C of your personal tax return, paying both income tax and self-employment tax (15.3% for Social Security and Medicare) on net profits. There are no separate business tax returns to file, no annual reports, and minimal administrative burden.

However, the major drawback is unlimited personal liability. If your business is sued or accumulates debt, your personal assets—your home, personal bank accounts, vehicles, and investments—are all at risk. This exposure makes sole proprietorships unsuitable for businesses with significant liability exposure, such as real estate investing, food services, or professional consulting where errors could result in substantial claims.

Many successful entrepreneurs start as sole proprietors to validate their business model, then transition to an LLC once revenue justifies the additional costs and complexity. The key is knowing when to make that transition—typically when you have significant assets to protect or when annual profits exceed $40,000-$50,000 where entity taxation benefits become meaningful.

Limited Liability Company (LLC): The Flexible Protector

The Limited Liability Company (LLC) has become the most popular business structure for small businesses, offering the liability protection of a corporation with the tax flexibility and administrative simplicity of a partnership. According to IRS data, LLC formations have grown 40% over the past decade, reflecting their versatility across industries.

An LLC creates a legal separation between you and your business. If the LLC is sued or defaults on debts, creditors generally cannot pursue your personal assets—only the assets held within the LLC. This protection, known as the "corporate veil," requires proper maintenance: keeping business and personal finances separate, maintaining adequate capitalization, following operating procedures, and never commingling funds.

Forming an LLC involves filing Articles of Organization with your state, typically costing between $50 and $500 depending on the state. You'll also need an Operating Agreement (even for single-member LLCs), an Employer Identification Number (EIN) from the IRS, and possibly business licenses specific to your industry and location. Annual fees vary widely—California charges an $800 minimum franchise tax, while Wyoming charges just $60 annually.

For real estate investors, LLCs serve a critical function. Many investors create separate LLCs for each property, ensuring that a lawsuit related to one property doesn't jeopardize others or personal assets. Others use a "series LLC" structure (available in states like Delaware, Nevada, and Texas) where each property operates as a separate series within one master LLC, reducing administrative costs while maintaining liability separation.

S-Corporation Election: Tax Savings for Profitable Businesses

The S-Corporation isn't actually a business structure—it's a tax election that LLCs or corporations can make with the IRS. This distinction confuses many entrepreneurs, but understanding it is crucial for tax optimization. By default, single-member LLCs are taxed as sole proprietorships, and multi-member LLCs as partnerships. Making an S-Corp election changes how you're taxed, potentially saving thousands in self-employment taxes.

Here's how the tax savings work: As a sole proprietor or LLC taxed as a disregarded entity, you pay 15.3% self-employment tax on all net business income. With an S-Corp election, you split your income into two categories—reasonable salary (subject to payroll taxes) and distributions (not subject to self-employment tax). The IRS requires S-Corp shareholders to pay themselves a "reasonable salary" based on industry standards, geographic location, and the services performed.

Let's examine the numbers. If your business earns $100,000 in net profit as a sole proprietor, you pay $15,300 in self-employment tax (before the income tax deduction on half of it). As an S-Corp, if you pay yourself a $50,000 reasonable salary, you pay $7,650 in payroll taxes on the salary, plus the employer portion of $7,650 is deductible. The remaining $50,000 distribution avoids self-employment tax entirely, saving approximately $7,650 annually—minus additional accounting costs of roughly $2,000-$3,000 for payroll and corporate tax returns.

The S-Corp election makes financial sense when your net profits exceed approximately $50,000 to $100,000 annually, depending on your state's taxes and your reasonable salary requirements. Below this threshold, the additional administrative costs outweigh the tax savings. The election must be made by March 15th of the tax year you want it to take effect, or you must wait until the following year.

C-Corporation: When the Traditional Structure Makes Sense

C-Corporations represent the traditional corporate structure used by major publicly traded companies, but they also serve specific purposes for small businesses. Unlike pass-through entities (LLCs, S-Corps, partnerships), C-Corps pay their own taxes at the corporate level—currently a flat 21% federal rate following the 2017 Tax Cuts and Jobs Act.

This flat rate can be advantageous for businesses reinvesting profits rather than distributing them to owners. If your business earns $200,000 and reinvests it all in growth, a C-Corp pays $42,000 in taxes (21%). An LLC owner in the 35% tax bracket would pay $70,000 in taxes on that same income, plus self-employment tax—a difference of $28,000 that stays in the business for expansion.

C-Corps also offer the most flexibility for raising capital. You can have unlimited shareholders, multiple classes of stock, and foreign investors—restrictions that apply to S-Corps. Venture capital firms and angel investors typically require C-Corp structures before investing, making this entity choice almost mandatory for tech startups seeking significant funding.

The major downside is "double taxation"—profits are taxed at the corporate level, then again as dividends when distributed to shareholders. However, strategies like reasonable salaries, fringe benefits, and retained earnings can minimize this impact. For businesses planning to reinvest heavily, go public, or seek venture capital, the C-Corp structure often provides the best foundation for growth.

Tax Implications: A Side-by-Side Comparison

Understanding the tax treatment of each business structure is essential for making an informed decision. Each structure handles income taxation, self-employment taxes, and deductions differently, creating significantly different outcomes depending on your income level and business goals.

Structure	Tax Treatment	Self-Employment Tax	Best For
Sole Proprietorship	Pass-through (Schedule C)	Full 15.3% on net income	Low-risk startups, <$40K profit
LLC (default)	Pass-through (Schedule C or 1065)	Full 15.3% on net income	Asset protection, flexibility
LLC (S-Corp)	Pass-through (1120-S)	Only on salary portion	$50K+ profit, service businesses
C-Corporation	Corporate (21%) + dividend tax	Only on salary	Reinvesting, venture capital

The qualified business income (QBI) deduction, established by the 2017 Tax Cuts and Jobs Act, provides an additional 20% deduction on pass-through income for most businesses. However, service businesses like law, accounting, and consulting face income limitations—phasing out completely for individuals earning over $207,500 (single) or $415,000 (married filing jointly). This deduction further complicates the entity selection decision and should be analyzed with a tax professional.

Liability Protection: Beyond the Corporate Veil

While LLCs and corporations provide liability protection, this protection isn't absolute. Courts can "pierce the corporate veil" if you fail to maintain proper separation between personal and business activities. Understanding and implementing proper protection strategies is essential for maintaining the liability shield you've established.

The first line of defense is proper documentation. Maintain an Operating Agreement or Bylaws, hold annual meetings (even if it's just you documenting decisions), keep minutes of major decisions, and file all required state reports on time. The second line is financial separation—never commingle personal and business funds, pay for personal expenses from business accounts, or vice versa. Use a dedicated business bank account and credit card for all business transactions.

Insurance forms your third layer of protection. General liability insurance, professional liability (errors and omissions) insurance, and property insurance transfer risk from your business to insurance companies. An umbrella policy providing $1-5 million in additional coverage typically costs $300-$600 annually—minimal cost for significant peace of mind.

For real estate investors, additional strategies include using land trusts to maintain privacy (the trust holds title while the LLC manages the property), ensuring properties are adequately capitalized with sufficient reserves for maintenance and vacancies, and maintaining a separate bank account for each property or LLC. Some sophisticated investors also establish Wyoming or Nevada holding companies that own their operating LLCs, adding another layer of protection and privacy.