How Entity Structure Affects Your Taxes

Choosing the right business entity structure is one of the most important tax decisions you’ll make. Your entity structure doesn’t just affect legal liability — it also determines how your business income is taxed, what deductions you’re eligible for, how you pay yourself, and how much you’ll owe in taxes. Make the wrong choice, and you could end up paying thousands more than necessary.

Step-by-Step Guide to Evaluating Entity Structures

1. Understand the Main Entity Types

• Sole Proprietorship – Simple setup, taxed on your personal return via Schedule C. No legal separation between you and the business.

• LLC (Limited Liability Company) – Offers liability protection, flexible tax treatment (can be taxed as sole prop, partnership, S corp, or C corp).

• Partnership – Used for two or more owners; income passes through to personal returns.

• S Corporation – Pass-through entity with potential savings on self-employment tax; requires payroll and formal structure.

• C Corporation – Separate tax entity; profits taxed at corporate level (and again at personal level if dividends are paid).

  
  

2. Identify How Each Affects Taxation

• Pass-through entities (sole props, partnerships, S Corps, LLCs) do not pay income taxes themselves. Profits are reported on the owners’ personal tax returns.

• C Corps pay corporate income taxes, which may be beneficial for retained earnings but create “double taxation” if profits are distributed.

  
  

3. Consider Your Goals

• Are you trying to reduce self-employment tax?

• Do you want to retain profits in the business?

• Will you raise capital or add investors?

• Do you plan to sell the business later on?

  
  

4. Run the Numbers

Use tax planning software or work with a tax advisor to model how much tax you’d owe under different structures. Sometimes an S Corp election can save tens of thousands per year — but only if you do it right.

5. Review IRS Guidelines and Compliance Rules

Each structure has its own filing requirements and forms. For example:

• S Corps must file Form 1120S

• Partnerships file Form 1065

• C Corps file Form 1120

• Sole props file Schedule C with Form 1040See IRS guidance here

  
  

Common Mistakes to Avoid

• Mistake #1: Forming an LLC and thinking it automatically changes your tax treatment (it doesn’t — you must elect to be taxed as an S Corp or C Corp if desired).

  
  

• Mistake #2: Choosing an S Corp but failing to run payroll — which can disqualify the election or trigger IRS penalties.

  
  

• Mistake #3: Not reviewing your structure as your income grows. What works for a $40K side hustle may cost you at $400K.

  
  

• Mistake #4: Thinking the cheapest option is always best. Sole props are easy, but often the most expensive in taxes over time.

Summary: Best Practices for Choosing the Right Structure

✅ Align your structure with your goals – growth, income, exit, liability

✅ Review annually – especially if your income or ownership changes

✅ Model tax savings – don’t guess; run real numbers

✅ Work with a professional – tax strategy pays for itself when done right

✅ Stay compliant – file the right forms and maintain good records

Need Help Choosing or Updating Your Entity Structure?

At Development Theory, we help small business owners reduce taxes and align their business structure with their financial goals. Whether you need to switch to an S Corp, structure a holding company, or prepare for a future sale, our tax strategy services ensure you're making the smartest move — not just the easiest.

Ready to review your structure? Book a free discovery call to see how much you could save.