Business tax is three systems, not one: the owner is taxed, the partners are taxed, or the corporation is taxed — and the choice of legal form decides which. This guide computes the same profit under each form, explains the S corporation salary-dividend split and the self-employed position inside the pass-through forms, and sets out how to choose a form for the business, with tax counted, not alone.

Three forms, three tax systems

Business tax is not one tax. It is three different systems, for three different legal forms, and the choice of form decides the system. A sole proprietorship and a single-member limited liability company are taxed as the owner: the business profit is the owner’s income, reported on the owner’s return, taxed at the owner’s rates, with self-employment tax on the profit. A partnership is taxed as the partners: the partnership files an information return, the profit is allocated to the partners, and each partner is taxed on their share, whether or not it is distributed, with self-employment tax on the active partners’ shares. A corporation is taxed as itself: the corporation pays tax on its profit, and the shareholders pay tax again on the dividends, with no self-employment tax on the dividends. The same $100,000 of profit therefore bears three different total tax burdens, depending on the form, and the form should be chosen for the business’s needs — liability, capital, succession — with the tax counted, not for the tax alone, because the form is hard to change and the tax is only one of its consequences.

The guide takes the three forms in turn, then the self-employed position that sits inside the first two, and then the features that cut across all three: deductions, payroll taxes, estimated payments, and the state layer. No current rates are printed as facts, because the rates, thresholds and brackets change, and because the comparison that matters is the total — the tax at every layer, on the same profit, under each form — computed with the figures for the year in question from the official sources. The worked examples use stated assumptions, labelled as such, to show the method; the method is the durable part, and the rates must be replaced with the year’s own figures whenever the comparison is run for real.

Sole proprietorships and single-member LLCs: the owner is the business

A sole proprietor reports the business on Schedule C: gross receipts, cost of goods sold, and expenses by category, giving net profit, which flows to the personal return and is taxed as ordinary income at the owner’s marginal rates, together with all other income. Self-employment tax is charged on the net profit, covering both halves of Social Security and Medicare, with half deductible in arriving at adjusted gross income. The simplicity is the attraction: one return, one computation, no separate entity tax, no dividend decision. The cost is the exposure: the owner’s personal assets are the business’s assets for liability purposes, the whole profit is taxed in the year it is earned whether or not it is withdrawn, and the self-employment tax applies to the whole profit, including the part retained in the business for growth. A sole proprietor who retains profit to fund expansion pays self-employment tax on money they never took home, which is the price of the form’s simplicity, and it is the reason growing businesses often move to a form that separates the owner’s pay from the business’s profit.

A single-member LLC, taxed by default as a sole proprietorship, is identical for federal tax purposes: the LLC’s liability protection does not change the tax, and the profit is still the owner’s income on Schedule C. The LLC may elect to be taxed as a corporation, and the election changes the system entirely, as described below — which is why the election, not the formation of the LLC, is the tax decision. State treatment differs: some states levy a fee or a tax on LLCs, and some treat the LLC as a separate taxpayer for state purposes, so the state layer must be checked separately from the federal. The federal position, however, is simple: a single-member LLC with no election is its owner, for tax, and the owner’s return is the business’s return.

Partnerships: profit allocated, taxed whether distributed or not

A partnership files Form 1065, an information return that computes the partnership’s profit and allocates it to the partners according to the partnership agreement, on Schedule K-1. Each partner reports their allocated share on their own return, taxed as ordinary income at their own rates, whether the partnership distributed the cash or retained it — the tax follows the allocation, not the distribution, which is the partnership’s defining feature and its principal cash-flow trap. A partner allocated $60,000 of profit of which $20,000 was distributed has $60,000 of taxable income and $20,000 of cash, and must fund the tax on the $40,000 retained from other resources or from a tax distribution the agreement should provide for. Partnership agreements that do not require tax distributions create this trap by omission, and the omission should be corrected in the agreement, not discovered at filing time.

Active partners pay self-employment tax on their share of the profit, like sole proprietors, while limited partners generally do not pay self-employment tax on their share, as passive investors — a distinction that follows the partner’s role, not the label, and that the tax authority tests on the facts. Guaranteed payments — fixed payments to a partner for services or capital, regardless of profit — are treated as ordinary income to the partner and as a deduction to the partnership, and they are subject to self-employment tax for the recipient. The partnership’s own deductions, depreciation, and credits flow through to the partners in the same allocation, and the partners’ individual circumstances — their other income, their deductions, their state of residence — then decide the tax on the allocated profit, partner by partner, on separate returns, from the same K-1.

Corporations: two layers, and the choice within them

A C corporation pays tax on its profit at the corporate rate, files its own return, and pays dividends from after-tax profit, which the shareholders tax as dividend income — qualified dividends at preferential rates where the holding and company conditions are met, ordinary dividends otherwise. The two layers are the system’s defining feature: the profit is taxed once in the corporation and again in the shareholder’s hands, and the combined rate is the sum of the two, less the interaction between them. The corporation’s profit retained in the business is taxed once, at the corporate rate, and is not taxed again until it is distributed, which makes the corporation the form that best accommodates retained profit: a growing business that reinvests its profit pays the corporate rate on the retained amount and defers the shareholder layer until distribution, while a sole proprietor pays both income and self-employment tax on the retained amount in the year it is earned.

An S corporation elects to be taxed like a partnership in one respect: the profit flows through to the shareholders, taxed on their returns, with no corporate-level tax, while the corporation remains a corporation for liability and for payroll purposes. The S corporation’s distinctive feature is the salary-dividend split: a shareholder-employee must be paid a reasonable salary for the work done, subject to payroll taxes, and the remaining profit may be distributed as a distribution, not subject to payroll taxes. The split is the planning opportunity and the audit risk in one: a salary set too low, to maximise the distribution and minimise payroll taxes, is challenged, and the tax authority recharacterises the distribution as salary, with payroll taxes and penalties. The salary must be reasonable for the work, comparable with what the business would pay a non-owner for the same work, and documented — and the distribution, however large, must follow a reasonable salary, not precede it.

The four forms compared. The same profit bears a different total burden under each, and the burden depends on the rates at each layer for the year in question — use the official figures for the comparison, not the assumed rates in the worked examples.

Self-employed tax: the position inside the pass-through forms

The self-employed position — the sole proprietor, the freelancer, the active partner — is the position described in the companion guide on self-employed income tax, and it is summarised here because it is the tax that decides the comparison for most small businesses. The profit is taxed as ordinary income and as self-employment tax, the two together are the burden, and the burden is paid in quarterly estimated instalments, because nothing is withheld. The self-employed person may reduce the profit with business expenses, with retirement contributions to a SEP IRA or a Solo 401(k), and with the health insurance deduction, and each reduction must be computed on the profit, not on the revenue, and documented as the business’s expense, not the owner’s personal cost. The estimated payments must cover both taxes, under the safe-harbour rules, and the separate tax account — a fixed share of every receipt, set aside on arrival — is the discipline that makes the instalments painless.

The comparison that matters for a growing sole proprietorship is with the S corporation: at what profit does the payroll-tax saving on the distribution exceed the S corporation’s costs — the payroll administration, the reasonable salary, the separate return, the state fees — and the answer depends on the profit, the salary, and the rates, computed year by year. There is no universal threshold, and a threshold quoted without the profit, the salary, and the rates is not advice; it is a slogan. The calculation is the comparison of the two totals, on the same profit, with the same salary, under the year’s rates, and it should be run with an accountant, because the salary’s reasonableness is a judgement the tax authority tests, and the judgement must be documented before it is tested.

Deductions, payroll taxes, and the state layer

Every form deducts the ordinary and necessary expenses of the business, and the deduction rules are substantially the same across forms: the expense must be ordinary, necessary, and documented, and the categories — rent, wages, supplies, travel, depreciation — are the same. The differences are in the expenses that are form-specific: the corporation deducts the salaries it pays, including the owner-employee’s salary, and the fringe benefits it provides; the partnership deducts guaranteed payments; the sole proprietor deducts the business expenses and claims the retirement and health deductions on the personal return. Depreciation — the spreading of an asset’s cost over its useful life under the prescribed schedules, with bonus depreciation and expensing elections where they apply — is available to every form, and the choice of method changes the timing of the deduction, not its total, which makes it a cash-flow decision as much as a tax decision.

Payroll taxes apply wherever there are employees, in every form: the employer withholds the employee’s share, pays the employer’s share, and remits both, with the wage base and the additional Medicare tax applied as described in the paycheck guide. The state layer adds a further tax in most states — a corporate income tax, a franchise tax, a gross receipts tax, or a pass-through entity tax — with its own base, its own rate, and its own filing, and the federal deduction for state taxes paid must be counted in the comparison, because a state tax that is deductible federally costs less than its face value. A multi-state business faces apportionment: the profit is divided among the states where the business operates, by sales, payroll, and property, under each state’s formula, and the compliance burden of the division is a real cost of operating across state lines, distinct from the tax itself.

Choosing the form, and changing it

The form should be chosen for the business, not for the year’s tax: liability protection, the ability to raise capital, the number and kind of owners, the exit plan, and the administrative burden are the primary considerations, and the tax is counted within them, not above them. A business that needs outside investors will usually be a corporation, because investors buy shares; a business owned by two professionals who will work in it will usually be a partnership or an LLC taxed as a partnership, because the profit flows through and the agreement governs the relationship; a business owned by one person, with no employees and no outside capital, will usually start as a sole proprietorship or a single-member LLC, because the simplicity outweighs the exposure at that scale. The tax comparison is run within the shortlist the business needs produce, not across every form in the abstract, and the winner is the form that serves the business at the lowest total cost, tax included, over the horizon the business is planned for.

Changing form is possible, and it is taxed: converting a sole proprietorship to a corporation, or a corporation to a pass-through, involves transfers of assets, assumptions of liabilities, and elections, each with its own tax consequence, and the conversion should be planned with advice, in the year before it takes effect, not discovered at filing time. The commonest conversion — a sole proprietorship electing S corporation status — is straightforward where the requirements are met: one class of stock, eligible shareholders, the election filed on time, and a reasonable salary established from the first payroll. The conversion’s benefit — the payroll-tax saving on the distribution — begins when the election takes effect, and the salary must be reasonable from that date, because the tax authority tests the salary for the whole period of the election, not merely for the year of an audit. A form chosen well, and changed deliberately, serves the business; a form chosen for a single year’s tax saving, and changed without advice, costs more than it saves.

Frequently asked questions

How is a sole proprietorship taxed?

The business profit is the owner’s income: it is reported on Schedule C, taxed as ordinary income at the owner’s marginal rates, and subject to self-employment tax on the whole profit, covering both halves of Social Security and Medicare. The profit is taxed in the year it is earned, whether or not it is withdrawn, and a single-member LLC with no election is taxed identically for federal purposes.

How is a partnership taxed?

The partnership files an information return and allocates its profit to the partners on Schedule K-1. Each partner is taxed on their allocated share at their own rates, whether or not the cash was distributed, so a partner can owe tax on profit retained in the business. Active partners pay self-employment tax on their shares; the agreement should provide for tax distributions so partners can pay the tax on allocated but undistributed profit.

How is a corporation taxed?

A C corporation pays tax on its profit at the corporate rate, and shareholders pay tax again on dividends — the two-layer system. Profit retained in the corporation is taxed once, at the corporate rate, until distributed. An S corporation elects flow-through treatment: the profit is taxed on the shareholders’ returns with no corporate-level tax, but a shareholder-employee must be paid a reasonable salary subject to payroll taxes, with the remaining profit distributed free of payroll taxes.

What is the difference between a C corporation and an S corporation?

A C corporation is taxed at both levels: corporate tax on profit, then shareholder tax on dividends. An S corporation is taxed once, at the shareholder level, on allocated profit. The S corporation’s planning opportunity — and audit risk — is the salary-dividend split: the salary must be reasonable for the work done, comparable with what a non-owner would be paid, and documented. A salary set too low to maximise distributions is recharacterised as salary, with payroll taxes and penalties.

Do self-employed workers pay self-employment tax on all their profit?

Yes, on net business profit, as the equivalent of both halves of payroll taxes, with half deductible in arriving at adjusted gross income. The tax applies to the whole profit, including profit retained in the business, which is why growing sole proprietorships often compare the position with an S corporation, where only the reasonable salary attracts payroll taxes. The comparison must be run on the same profit, with the same salary, under the year’s rates.

Can a business change its tax form?

Yes, by election or conversion, but the change is itself a taxable event in many cases, involving asset transfers, liability assumptions and elections with their own consequences. A sole proprietorship electing S corporation status is the commonest conversion, and it requires eligible shareholders, one class of stock, a timely election, and a reasonable salary from the first payroll. Plan the change with advice in the year before it takes effect.