Choosing Your Business Entity: A Decision Framework

Why Entity Choice Matters

Choosing your business entity is one of the first real decisions you make as a business owner, and it affects everything: how much you pay in taxes, how much personal risk you carry, how easy it is to raise money, and how much paperwork you deal with every year.

The good news: for most small businesses, the right answer is straightforward. The bad news: the wrong answer can cost you thousands in unnecessary taxes or leave your personal assets exposed to business liabilities.

Let us work through a practical framework.

The Five Main Options

1. Sole Proprietorship

Best for: Side hustles, very early stage businesses, freelancers testing an idea
Liability protection: None
Tax treatment: Schedule C on personal return, plus self-employment tax
Formation cost: $0 (just a DBA filing if not using your name)
Annual compliance: Minimal

2. Single-Member LLC

Best for: Solo business owners who want liability protection
Liability protection: Yes — personal assets shielded from business liabilities
Tax treatment: Same as sole proprietorship by default, but can elect S-Corp or C-Corp taxation
Formation cost: $50-$500 depending on state
Annual compliance: Low to moderate (annual report, franchise tax in some states)

3. Multi-Member LLC

Best for: Business partnerships where all owners want liability protection
Liability protection: Yes
Tax treatment: Partnership by default (Form 1065 + K-1s), can elect S-Corp or C-Corp
Formation cost: $50-$500 depending on state
Annual compliance: Moderate

4. S-Corporation (LLC or Corp with S-Corp election)

Best for: Profitable businesses looking to reduce self-employment tax
Liability protection: Yes
Tax treatment: Pass-through, but owner-employees pay payroll tax only on salary, not distributions
Formation cost: LLC or Corp formation fees + Form 2553 filing
Annual compliance: High — payroll, corporate tax return, annual reports

5. C-Corporation

Best for: Businesses raising venture capital, planning an IPO, or retaining significant earnings
Liability protection: Yes
Tax treatment: Double taxation — corporate tax (21%) plus dividend tax
Formation cost: $100-$500 depending on state
Annual compliance: Highest — board meetings, shareholder meetings, corporate minutes, annual reports

The Decision Framework

Answer these five questions to narrow your choice:

Question 1: Are you testing an idea or running a real business?

If you are just testing an idea, doing occasional freelance work, or earning less than $20,000/year from a side project, a sole proprietorship is fine for now. The moment you decide this is a real business — meaning you are committed to it and it generates meaningful income — form an LLC.

Question 2: Do you have partners?

No partners: Single-member LLC
Active partners (everyone works in the business): Multi-member LLC
Mix of active operators and passive investors: Consider an LP structure or multi-member LLC with a clear operating agreement distinguishing roles

Question 3: What is your net business income?

Under $60,000/year: LLC taxed as a sole proprietorship or partnership. The S-Corp election adds cost and complexity that outweigh the tax savings at this level.
$60,000-$80,000/year: Run the numbers with a CPA. The S-Corp may start making sense, but it depends on your specific situation.
Over $80,000/year: Strongly consider the S-Corp election. The self-employment tax savings typically far exceed the compliance costs.
Retaining large profits for business reinvestment: The C-Corp's 21% rate may be advantageous. Talk to your CPA.

Question 4: Do you plan to raise outside investment?

No outside investment: LLC with optional S-Corp election
Friends and family or angel investors: LLC may work, but some investors prefer corporate structure
Venture capital or institutional investment: C-Corp, almost certainly incorporated in Delaware

Question 5: What state are you in?

State laws and taxes can swing the decision:

California: $800 minimum annual franchise tax for LLCs and corporations. This makes an LLC expensive if you are barely profitable. Some early-stage businesses remain sole proprietorships longer in California for this reason.
New York: LLC publication requirement can cost $1,000+, though recent reforms have reduced costs in some counties.
Texas: No state income tax, making pass-through structures particularly attractive.
Wyoming and Nevada: No state income tax and low filing fees, popular for holding companies but usually not worth it for operating businesses based elsewhere.

Common Scenarios and Recommendations

The Solo Contractor

You do residential or commercial contracting work by yourself, or with a small crew of subcontractors. Revenue is $80,000-$250,000.

Recommended: Single-member LLC with S-Corp election. The liability protection covers you on job sites, and the S-Corp election saves you meaningful self-employment tax.

The Freelance Consultant

You do consulting or professional services, working from home or a small office. Revenue is $50,000-$150,000.

Recommended: Single-member LLC. If income exceeds $80,000 consistently, add the S-Corp election.

Two Partners Starting a Service Business

You and a partner are launching a landscaping, HVAC, or general contracting company together. You both work in the business full time.

Recommended: Multi-member LLC with a thorough operating agreement. Once profitable above $80,000, consider S-Corp election.

The Tech Startup Seeking Funding

You are building a product with plans to raise angel or VC money within a year or two.

Recommended: C-Corp incorporated in Delaware. This is what investors expect, and converting later is expensive and complicated.

The Real Estate Investor

You own rental properties and want liability protection for each one.

Recommended: Separate single-member LLCs for each property, possibly held under a parent LLC or holding company.

Mistakes People Make

Choosing based on what sounds impressive. "Corporation" sounds more legitimate than "LLC" to some people. That is not a reason to choose a structure that costs you thousands more in taxes and compliance.

Forming a C-Corp because someone told them to. Unless you are raising VC money, a C-Corp is almost certainly the wrong choice for a small business.

Staying a sole proprietor too long. Once you have real income and real risk, the liability protection of an LLC is worth the modest cost.

Making the S-Corp election too early. If your income does not support it, you are paying for payroll and tax prep with no net benefit.

Not revisiting the decision. Your business changes. What made sense at $50,000 in revenue may not make sense at $500,000. Revisit your entity structure annually with your CPA.

Bottom Line

For most small business owners, the path is clear: start as a sole proprietorship if you must, form an LLC as soon as the business is real, and add the S-Corp election once your income justifies it. Save the C-Corp for when you are raising institutional capital. And no matter what you choose, get proper insurance, keep your finances separate, and work with a CPA who understands small business tax strategy.