Entity Selection: The Complete Tax Analysis — LLC vs. S-Corp vs. C-Corp vs. Partnership

The Entity Decision Framework: What You're Actually Choosing Between

When a client asks "should I be an LLC or an S-Corp?" they are usually asking the wrong question. The real question is: what is the optimal tax treatment for this business's income, given the owner's total income picture, the business's growth trajectory, and the exit strategy? Entity selection is not a one-time decision — it should be reviewed annually as income levels change and as the business evolves.

The four main structures for a small business owner are: (1) sole proprietorship / single-member LLC (disregarded entity), (2) S-Corporation, (3) C-Corporation, and (4) partnership / multi-member LLC. Each has a different tax treatment for the owner's income, different self-employment tax exposure, different access to fringe benefits, and different implications for the QBI deduction. The right choice depends on the specific numbers.

Sole Proprietorship / Single-Member LLC: The Default and Its Cost

A single-member LLC that has not made an S-Corp or C-Corp election is treated as a disregarded entity for federal tax purposes. All net income flows to Schedule C on the owner's Form 1040 and is subject to both income tax and self-employment tax. The SE tax rate is 15.3% on net SE income up to the Social Security wage base ($184,500 in 2026) and 2.9% above that (plus the 0.9% Additional Medicare Tax on SE income over $200,000 for single filers).

The effective SE tax burden on a Schedule C business with $150,000 of net profit is approximately $21,195 (15.3% × $150,000 × 92.35% — the SE income multiplier). This is the baseline that all other structures are compared against. The SE tax deduction (50% of SE tax) reduces income tax but does not reduce SE tax itself.

The QBI deduction under IRC §199A allows a 20% deduction on qualified business income for pass-through entities, including sole proprietors. For a Schedule C business with $150,000 of net profit, the QBI deduction is $30,000, reducing taxable income to $120,000. This is a significant benefit that was made permanent by the OBBB — previously it was scheduled to expire after 2025.

S-Corporation: The SE Tax Savings Engine

The primary tax advantage of an S-Corp election is the ability to split business income between W-2 wages (subject to payroll taxes) and S-Corp distributions (not subject to payroll taxes). An S-Corp owner who pays themselves a "reasonable compensation" W-2 salary and takes the remainder as a distribution avoids SE tax on the distribution portion.

When the S-Corp Makes Sense

The S-Corp election is generally beneficial when net business profit exceeds approximately $40,000–$50,000 per year. Below that threshold, the administrative costs of maintaining an S-Corp (payroll processing, separate tax return, state filing fees) typically exceed the SE tax savings. Above $40,000–$50,000, the savings grow linearly with income up to the Social Security wage base ($184,500 in 2026), above which only the 2.9% Medicare portion of SE tax is saved.

S-Corp Limitations

S-Corps have significant restrictions: maximum 100 shareholders, all shareholders must be US citizens or resident aliens, only one class of stock is permitted, and S-Corps cannot be owned by C-Corps, other S-Corps, or most trusts. These restrictions make S-Corps unsuitable for businesses seeking outside investment, venture capital, or complex equity structures. Additionally, S-Corp owners cannot deduct health insurance premiums as a business expense in the same way C-Corp employees can — the premiums are included in W-2 wages and then deducted on Schedule 1 as a self-employed health insurance deduction.

C-Corporation: The 21% Rate and When It Wins

The C-Corp flat tax rate of 21% (preserved by the OBBB) is lower than the top individual rates of 37%. For a business that retains earnings rather than distributing them, the C-Corp can be advantageous — profits are taxed at 21%, and the owner only pays individual tax when dividends are distributed or the business is sold. This "deferral" of individual tax can be powerful for high-growth businesses that reinvest all profits.

However, the double taxation problem is real. When a C-Corp distributes profits as dividends, the shareholder pays qualified dividend rates (0%, 15%, or 20% depending on income) on top of the 21% corporate tax. At the top rate, the combined effective rate is approximately 36.8% (21% corporate + 20% dividend + 3.8% NIIT on dividends), which is comparable to the top individual rate. The C-Corp advantage disappears when profits are distributed.

The C-Corp is most advantageous for: (1) businesses that retain and reinvest all profits; (2) businesses seeking venture capital or outside investment (VCs require C-Corp structure); (3) businesses planning to issue QSBS under §1202 (which requires C-Corp status); and (4) businesses with employees who will benefit from C-Corp fringe benefits (health insurance, group-term life, dependent care FSA, educational assistance) that are fully deductible by the corporation and tax-free to employees.

The Decision Matrix: Which Structure Wins at Each Income Level

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