By: John S. Morlu II, CPA
Starting a new business is exciting, but it comes with important decisions that can have long-term consequences—especially when it comes to taxes. One of the first and most critical choices an entrepreneur must make is deciding on the type of business entity. This choice determines how the business is taxed, how profits and losses are handled, and what administrative responsibilities are required. While it is possible to change the business entity later, doing so can be a complex process with potential tax implications.
In recent decades, several significant changes have shaped the landscape of entity selection, including:
- The Tax Cuts and Jobs Act (TCJA) of 2017, which dramatically altered business tax rates.
- The growing popularity of Limited Liability Companies (LLCs) due to their flexibility.
- Lower capital gains tax rates compared to ordinary income tax rates.
- The increasing use of pass-through entity (PTE) elections, especially in states with high taxes.
Additionally, rising self-employment (SE) taxes since the 1980s have made minimizing these taxes a primary concern for many small business owners. This article explores the advantages and disadvantages of different business entities to help you make an informed decision.
Overview of Business Entities: Pros and Cons
Each type of business entity comes with unique tax advantages and disadvantages. The following tables break down the main features of the most common entity types:
Sole Proprietorship
| Tax Advantages | Tax Disadvantages |
| Single layer of taxation | Net income subject to SE tax |
| Eligible for the Qualified Business Income (QBI) deduction | No salary deduction for the owner on Schedule C |
| Simple tax filing (Schedule C with Form 1040) |
- Best for: Entrepreneurs seeking a simple setup and minimal administrative burden.
- Considerations: While easy to start, the SE tax burden can be significant, especially for profitable businesses.
Partnership
| Tax Advantages | Tax Disadvantages |
| Single layer of taxation | General partners’ income is subject to SE tax |
| QBI deduction | Complex tax rules for partnerships |
| Flexible allocation of income, losses, etc. | Fringe benefits often treated as guaranteed payments |
| Distributive income for limited partners not subject to SE tax | |
| PTE elections in many states for SALT deductions |
- Best for: Businesses with multiple owners seeking flexibility in income allocation.
- Considerations: The complexity of partnership tax rules may require professional guidance.
LLC (Limited Liability Company)
| Tax Advantages | Tax Disadvantages |
| Can choose taxation as a partnership, S corporation, or C corporation | SE tax applies to distributive income unless taxed as a corporation |
| Flexible profit and loss allocation | Fringe benefits may need to be guaranteed payments for members |
- Best for: Owners who value flexibility and anticipate future changes in their business.
- Considerations: While versatile, choosing the wrong tax classification could increase tax liability.
C Corporation
| Tax Advantages | Tax Disadvantages |
| Flat 21% corporate tax rate | Subject to double taxation (corporate profits and dividends) |
| Deductible fringe benefits | Unfavorable treatment of capital gains and losses |
| State and local taxes deductible at the entity level | Limited options for offsetting losses outside corporate income |
- Best for: Larger businesses or those planning to reinvest profits heavily.
- Considerations: Double taxation can erode earnings for owners looking to take distributions.
S Corporation
| Tax Advantages | Tax Disadvantages |
| Single layer of taxation | Strict qualification rules (e.g., one class of stock, limited shareholders) |
| QBI deduction | Profits allocated strictly by ownership percentage |
| Income not subject to SE tax | |
| PTE elections in many states for SALT deductions |
- Best for: Business owners who want to avoid SE taxes and still maintain pass-through taxation.
- Considerations: The administrative requirements and restrictions may limit flexibility.
Which Business Entity is Right for You?
Choosing the best entity type depends on the business owner’s goals and tax needs. Here are some scenarios to consider:
1. Minimizing SE Taxes
If reducing SE taxes is a priority, an S corporation could be the best option. By designating a reasonable salary for the owner and treating remaining profits as distributions, SE taxes can be significantly reduced.
2. Flexibility for Uncertain Futures
For business owners unsure about their long-term strategy, an LLC offers unparalleled flexibility. LLCs allow you to “check the box” and switch between taxation as a partnership, S corporation, or C corporation as the business evolves.
3. Simplified Setup and Operation
If simplicity and minimal administrative overhead are the goals, a sole proprietorship or single-member LLC may be the way to go. However, this comes with trade-offs, such as higher SE taxes.
4. Long-Term Growth and Reinvestment
For businesses planning to reinvest most profits or seeking outside investors, a C corporation may be ideal. Its 21% flat tax rate on earnings allows for efficient reinvestment, though double taxation can be a drawback for distributed profits.
Making the Decision: Balancing Pros and Cons
There’s no “perfect” business entity—each comes with its trade-offs. A skilled tax practitioner can help weigh the advantages and disadvantages of each option, ensuring the decision aligns with the owner’s goals. For example:
- Highlighting the ease of a sole proprietorship while explaining the SE tax burden.
- Demonstrating the flexibility of an LLC while pointing out potential administrative complexities.
By focusing on clarity and providing actionable advice, tax professionals empower business owners to make informed decisions that set their businesses up for success.
Conclusion
Selecting the right business entity is one of the most critical decisions a business owner will make. It shapes not only the tax implications but also the administrative and operational flexibility of the business. With careful planning and the right guidance, entrepreneurs can choose an entity type that meets their needs today while allowing room for growth and change in the future.
Author: John S. Morlu II, CPA
John Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
The firm’s groundbreaking innovations include:
• ReckSoft (www.ReckSoft.com): AI-driven reconciliation software revolutionizing financial accuracy and efficiency.
• FinovatePro (www.FinovatePro.com): Advanced cloud accounting solutions empowering businesses to thrive in the digital age.
• Fixaars (www.fixaars.com): A global handyman platform reshaping service delivery and setting new benchmarks in convenience and reliability.
Under his strategic vision, JS Morlu continues to set the gold standard for technological excellence, efficiency, and transformative solutions.
