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Why this topic matters
Entity Tax Planning is Area III of Tax Compliance and Planning (TCP). Choosing between a sole proprietorship, partnership or limited liability company (LLC), S corporation, and C corporation affects taxes on operations, compensation, losses, fringe benefits, raising capital, and the eventual exit. The One Big Beautiful Bill Act (OBBBA) made both the 21% corporate rate and the 20% qualified business income (QBI) deduction permanent, so the comparison is now stable.
Side-by-side comparison
| Sole proprietorship / single-member LLC | Partnership / multi-member LLC | S corporation | C corporation | |
|---|---|---|---|---|
| Liability protection | None (proprietorship) / yes (LLC) | General partners unlimited; LLC members and limited partners protected | Yes | Yes |
| Level of tax | Owner only | Partners only | Shareholders only (plus certain entity-level taxes) | Twice — 21% at the corporation, then dividends to shareholders |
| Owners | One | Two or more; any type | ≤ 100 eligible shareholders; no nonresident aliens, partnerships, or corporations | Unlimited, any type |
| Allocations | — | Flexible special allocations | Strictly per share, per day | — |
| Basis from entity debt | — | Yes | No (only direct shareholder loans) | — |
| Self-employment tax | On all net earnings | General partners on their share | Only on reasonable salary (payroll tax) | Only on wages |
| QBI deduction (20%) | Yes | Yes | Yes (not on salary) | No — flat 21% instead |
| Losses | Pass through | Pass through | Pass through | Trapped in the corporation (net operating losses) |
| Owner fringe benefits | Limited | Limited | Limited for > 2% shareholders | Fully deductible and excludable for owner-employees |
| Capital raising | Hard | Moderate | One class of stock limits investors | Easiest — preferred stock, venture capital, public markets |
| Qualified small business stock exclusion | No | No | No | Yes |
Comparing the tax cost of profits
EXAMPLE: A business earns $100 of profit; the owner is in the 37% bracket and qualifies for the full QBI deduction.
Pass-through: taxable income = $100 − 20% QBI deduction = $80 × 37% = $29.60 (plus self-employment tax or the 3.8% net investment income tax, depending on facts).
C corporation, all profits distributed: corporate tax $21; the remaining $79 paid as a qualified dividend taxed at 20% + 3.8% = $18.80. Total = $39.80.
C corporation, profits retained: only $21 now — attractive for businesses that reinvest, but watch the accumulated earnings tax and personal holding company tax.
When each entity tends to fit
- Partnership or LLC: real estate and investment ventures (basis from debt, flexible allocations, tax-free distributions of property), joint ventures, and businesses with varied owners.
- S corporation: profitable owner-operated service or trade businesses where salary plus distributions reduces payroll taxes.
- C corporation: high-growth start-ups raising venture capital, especially where qualified small business stock (Section 1202) could exclude gain — for stock issued after July 4, 2025, 50% after 3 years, 75% after 4, and 100% after 5, up to $15 million per issuer; businesses reinvesting most profits; companies planning an initial public offering.
- Sole proprietorship / single-member LLC: simple, low-profit ventures — often converting later.
Classification and conversions
- Check-the-box rules: an eligible entity (such as an LLC) can elect to be taxed as a corporation (and then as an S corporation). Default: single-member → disregarded; multi-member → partnership. A corporation under state law can't be treated as a partnership.
- Converting a partnership or LLC to a corporation is usually tax-free under Section 351 (80% control), but watch liabilities in excess of basis.
- Converting a C corporation to a partnership or LLC is a taxable liquidation — the corporation and shareholders are taxed on appreciation. It's much easier to go from pass-through to corporation than the reverse.
- C to S election: no immediate tax, but the built-in gains tax applies for 5 years.
Other structuring considerations
- Exit strategy: buyers want a basis step-up — easy with pass-throughs (asset sale, or a Section 754 election for partnership interests); C corporation asset sales cause double tax, so C corporation owners usually sell stock.
- State taxes: pass-through entity tax elections avoid the individual state and local tax deduction cap; some states tax LLCs or S corporations at the entity level.
- Multiple entities: holding real estate in an LLC and leasing it to the operating company separates liability and can create rental income; management companies and family structures shift income within limits.
- Compensation and retirement: C corporations offer the most flexible benefit plans; all entities can sponsor retirement plans.
How it is tested
- Recommend an entity for a fact pattern.
- Compute the combined tax on profits for pass-through versus C corporation structures.
- Identify consequences of converting between entity types.
- Weigh qualified small business stock, fringe benefits, losses, and exit strategy.
EXAM TIP: If the facts mention outside investors, venture capital, reinvesting all profits, or a future stock sale that could qualify for the Section 1202 exclusion, lean toward a C corporation. If they mention losses, real estate, flexible allocations, or distributing all profits, lean toward a pass-through.