In 2025, choosing your business entity isn’t just about paperwork — it’s about shaping your tax future. The numbers alone show how much this decision matters. Over 90% of U.S. businesses are set up as pass-throughs, meaning profits are reported once on the owner’s tax return. In fact, pass-through income topped $2.6 trillion in 2022. LLCs are leading the charge here — about 72.7% of new partnerships were LLCs — because they give business owners a blend of flexibility and liability protection.
On the flip side, C corporations still carry weight in the market, but they’re taxed differently. They face a flat 21% federal tax rate, and then any distributed dividends are taxed again on the shareholder’s return, the “double tax” problem.(1) And with the 20% Qualified Business Income (QBI) deduction set to expire after 2025, business owners are under even more pressure to think carefully about whether a sole proprietorship, LLC, or S Corp is the best fit.
How Business Structure Affects Your Taxes
The way you set up your business changes how your income is reported and taxed. For pass-through entities like sole proprietors, partnerships, LLCs, and S Corps, profits show up directly on your 1040. In 2022 alone, nearly 26 million taxpayers claimed the QBI deduction — which allows many business owners to deduct up to 20% of their qualified income.(2)
Here are a couple of things that make a big difference in practice:
- Self-employment taxes. Sole proprietors and default LLCs pay 15.3% on all profits, capped at the Social Security wage base ($176,100 in 2025). S Corps, however, can split income between salary (taxed for FICA) and distributions (which skip self-employment tax). That’s where real savings kick in.
- State-level rules. States have their own twists. California hits LLCs with an $800 franchise fee, while Texas charges a margin tax of 0.75% (0.375% for retail/wholesale). Some states don’t even allow the federal QBI deduction.
Other nuances include health insurance reporting for S Corp shareholders, built-in gains tax on C-to-S conversions, and even §1202 Qualified Small Business Stock (QSBS), which can let C Corp owners exclude up to $10M in capital gains after five years. Translation? It’s complicated — and that’s why strategy matters.
Sole Proprietor
A lot of people start as sole proprietors because it’s the easiest path. You don’t have to file extra paperwork—you just report your income and expenses on a Schedule C. But here’s the catch: you’re personally on the hook for everything. If a client sues you, or the business racks up debt, your house, your car, even your savings account could be at risk.
From a tax perspective, every dollar of profit is subject to self-employment tax, which is 15.3% in 2025. That covers both the employer and employee share of Social Security and Medicare. Sure, you can deduct half of it for income tax purposes, but it still adds up fast. And unlike LLCs or S Corps, there’s no flexibility here—you can’t split income or play with payroll to cut that tax bill down.
For freelancers, side hustlers, and very small operations, the simplicity of sole proprietorship can make sense. But once you start making real money—or want to protect your personal assets—it’s time to level up.
LLC (Single- or Multi-Member)
LLCs are the middle ground. They give you a legal shield between your business and personal assets, which is huge. In California, if your business gets sued, only the business assets are at risk—your home and personal accounts are generally safe, as long as you keep things clean and separate. That means no commingling funds or skipping basic recordkeeping, or a court can “pierce the veil” and come after you personally.
Tax-wise, an LLC is flexible. By default, a single-member LLC is taxed like a sole proprietor, and a multi-member LLC is taxed like a partnership. But here’s where it gets interesting: you can elect to be taxed as an S Corp once your profits justify the added compliance. That’s why many of my clients start as an LLC and then switch once they hit that $70K–$100K profit range.
The downside? California hits every LLC with an $800 annual franchise tax, and if your revenue tops $250,000, you’ll owe an extra fee that scales up with gross receipts. That fee can really sting if you’re running a high-revenue, low-margin business. But for most small businesses, the liability protection and future flexibility make LLCs a solid choice.
S Corporation
The S Corp is where things start to get interesting. Unlike a sole proprietor or default LLC, you don’t have to pay self-employment tax on all your profits. Instead, you split your income into two buckets: a reasonable salary, which is subject to payroll taxes, and distributions, which are not. For many of my clients, this setup saves thousands every single year.
But the IRS is very picky about what counts as a “reasonable salary.” Pay yourself too little and they’ll reclassify your distributions as wages, hit you with back taxes, and possibly penalties. That’s one of the most common audit issues I see with the S Corps.
There’s also more paperwork. You have to run payroll, issue W-2s, and file an 1120-S every year. You also need to respect corporate formalities like keeping meeting minutes and separating personal and business funds. Luckily, with today’s payroll software, most of these headaches are easier to manage than they used to be.
In California, S Corps pay the same $800 franchise tax as LLCs, plus a 1.5% tax on net income. Depending on your profit level and business type, this can actually be cheaper than the LLC’s gross receipts fee. For service-based businesses making steady profits, S Corps can be a tax-smart move.
Tax Comparison Table: Pros and Cons
| Business Structure | Tax Forms Required | Tax Treatment | Self-Employment Tax | Liability Protection | Payroll Needs | Audit Risk | Best For |
| Sole Proprietor | Schedule C + SE | Pass-through | 15.3% on all profits | None | No | Low | Freelancers, side hustlers |
| LLC (Default) | Schedule C (single-member) or Form 1065 (multi-member) | Pass-through | 15.3% on profits | Limited | No (unless S Corp) | Medium | Growing small businesses |
| LLC taxed as S Corp | Form 1120-S + Payroll filings | Pass-through | Only on salary | Limited | Yes | Higher | Businesses with $60k+ net income |
| S Corporation | Form 1120-S + Payroll filings | Pass-through | Only on salary | Limited | Yes | Higher | Scaling businesses with employees |
When to Consider Reclassifying Your Entity
The sweet spot for moving into an S Corp usually comes when you’re netting $70K–$100K or more. That’s the range where the payroll tax savings outweigh the extra costs of compliance. If you’re planning to grow, hire employees, or even bring on investors, stepping into an LLC taxed as an S Corp—or going straight S Corp—can set you up for smoother scaling.
On the flip side, if you’re just testing the waters or making side income, a sole proprietorship or LLC might be the right fit until your profits stabilize.
Conclusion
Choosing between sole proprietor, LLC, and S Corp isn’t just about taxes—it’s about how you want to grow, protect, and run your business. Sole proprietorships keep things simple but expose you personally. LLCs give you protection and options, but California’s fees can add up. S Corps demand more compliance but reward profitable owners with significant tax savings.
This isn’t a one-size-fits-all decision. What makes sense for a freelance designer in Burbank may not work for a growing production company or a rental property investor. That’s why I always tell my clients: don’t just Google this stuff—get real advice that matches your business and your future goals.
At America Tax Group here in Burbank LA, we help business owners make smart calls on entity choice, save money on taxes, and avoid the kind of mistakes that lead to IRS headaches.
👉 Ready to figure out the best structure for your business? Let’s sit down and build a strategy that works for you today—and sets you up for success tomorrow.
FAQs
1. What’s the tax benefit of switching to an S Corp?
Switching to an S Corp can reduce self-employment tax. You only pay payroll taxes on your reasonable salary, while distributions avoid the 15.3% self-employment tax.
2. Does an LLC save more on taxes than a sole proprietorship?
Not by default. Both are taxed as pass-through entities. The tax savings only come if the LLC elects S Corp taxation. Otherwise, both pay full self-employment tax.
3. Do I need to pay myself a salary in an S Corp?
Yes. The IRS requires S Corp owners to pay themselves a “reasonable salary” subject to payroll taxes before taking additional profits as distributions.