Ch8. Business Entity Taxes — LLC, S-Corp, C-Corp, and Pass-Through Taxation

Why Entity Choice Matters

The legal structure of your business determines how its income is taxed, which forms you file, and what deductions are available. The choice between a sole proprietorship, LLC, S-Corp, and C-Corp can mean tens of thousands of dollars per year in tax differences.

Sole Proprietorship / Single-Member LLC (Disregarded Entity)

The default for solo business owners. All income and expenses flow directly to Schedule C of Form 1040.

Self-Employment Tax (SE Tax):
  15.3% on net self-employment income up to $168,600 (2024)
  (12.4% Social Security + 2.9% Medicare)
  2.9% Medicare tax on income above $168,600
  Additional 0.9% Medicare surcharge above $200,000 (single) / $250,000 (MFJ)

Above-the-line deduction:
  You can deduct the employer-equivalent half (7.65%) of SE tax from gross income
  This reduces AGI — available whether or not you itemize

Example: $100,000 net Schedule C income
SE tax:          $100,000 × 92.35% × 15.3% = $14,130 (approx.)
Income tax on:   $100,000 − $7,065 (deduction) = $92,935 of ordinary income

Partnership and Multi-Member LLC

Two or more owners. Files Form 1065 (information return); each partner receives a Schedule K-1 showing their share of income, deductions, and credits.

Key features:
→ Pass-through: income taxed to partners at their individual rates
→ Flexibility in profit/loss allocation (subject to economic substance rules)
→ Partners who are active in the business pay SE tax on their distributive share

S-Corporation

An S-Corp is a pass-through entity that can reduce self-employment taxes by splitting income between a “reasonable salary” (subject to FICA) and distributions (not subject to SE tax).

Structure:
  S-Corp net income = Salary (FICA-taxed) + Distribution (no SE tax)

Example: $200,000 net profit
  Sole proprietor: SE tax on ~$200,000 = ~$28,000 SE tax
  S-Corp (salary $100,000, distribution $100,000):
    SE tax on salary:     $100,000 × 15.3% = $15,300
    SE tax on distribution: $0
    SE tax saving: ~$12,700

Requirement: must pay yourself a "reasonable compensation"
→ IRS scrutinizes excessively low salaries to avoid payroll tax

S-Corp Eligibility Requirements

✓ Domestic corporation
✓ No more than 100 shareholders
✓ All shareholders are US citizens or residents
✓ Only one class of stock
✓ Cannot be a bank, insurance company, or certain other entities

C-Corporation

C-Corps are separate taxpaying entities — income is taxed at the corporate level, then again when distributed as dividends (double taxation).

Corporate Tax Rate: flat 21% (Tax Cuts and Jobs Act, 2017)

Double Taxation:
  Corporate profit:   $1,000,000
  Corporate tax (21%): $210,000
  After-tax profit:   $790,000
  Dividend paid:      $790,000
  Shareholder tax (qualified dividend, 15%): $118,500
  Total tax:          $328,500 (effective ~32.9%)

vs. S-Corp or LLC:
  $1,000,000 × ~37% top individual rate = $370,000 (worst case)
  But lower rate owners may pay less via pass-through

When C-Corp Makes Sense

✓ Seeking venture capital (VCs prefer C-Corps; S-Corp restrictions apply)
✓ Planning for IPO
✓ Expecting long reinvestment phase (retain earnings at 21% vs. 37% pass-through)
✓ Qualified Small Business Stock (QSBS) exclusion: up to 100% capital gains exclusion
  on C-Corp stock held >5 years (up to $10 million gain)

The 20% QBI Deduction (Section 199A)

Pass-through business owners (sole props, partnerships, S-Corps) may deduct up to 20% of qualified business income (QBI) from taxable income.

Basic calculation:
  QBI Deduction = 20% × QBI (subject to limitations)

Limitations phase in for higher-income taxpayers:
  Single: phaseout begins at $191,950 (2024)
  MFJ:    phaseout begins at $383,900

Specified Service Trades or Businesses (SSTBs):
  Law, accounting, consulting, financial services, etc.
  → QBI deduction phases out completely above income thresholds

Non-SSTB businesses:
  At high income, deduction limited to the greater of:
  (a) 50% of W-2 wages paid, or
  (b) 25% of W-2 wages + 2.5% of unadjusted basis of qualified property

Example: Single, taxable income $150,000, QBI = $80,000 (non-SSTB)
QBI deduction: $80,000 × 20% = $16,000
  (under phaseout threshold, no wage/property limitation applies)
Taxable income after deduction: $150,000 − $16,000 = $134,000

Retirement Plans for Business Owners

Business owners have access to higher-limit retirement plans than employees.

SEP-IRA:
  Contribution: up to 25% of net self-employment income
  2024 limit:   $69,000
  Simple to set up; no annual filing required

Solo 401(k) (Individual 401(k)):
  Employee contribution: $23,000 ($30,500 age 50+)
  Employer contribution: up to 25% of compensation
  2024 combined limit:   $69,000 ($76,500 age 50+)
  Can invest in almost anything; Roth option available

SIMPLE IRA:
  For businesses with ≤100 employees
  2024 limit: $16,000 ($19,500 age 50+)
  Employer must match up to 3% or contribute 2% flat

Entity Selection Summary

Entity	Tax Treatment	SE Tax	Complexity	Best For
Sole Prop / SMLLC	Schedule C (pass-through)	Full SE tax	Low	Solo, low income
Multi-member LLC	Form 1065 (pass-through)	Active partners pay SE	Low-Medium	Small partnerships
S-Corp	Pass-through, K-1	Salary only	Medium	>~$80K net profit
C-Corp	Double taxation (21%)	No SE	High	VC-backed, IPO, QSBS

Practice Quiz

Q1. You are a self-employed consultant earning $120,000 net. What is your approximate SE tax?

Net SE income = $120,000 × 92.35% =$ 110,820.
SE tax = $110,820 × 15.3% ≈ **$ 16,955**.

Q2. Why would a business owner elect S-Corp status rather than staying a sole proprietor?

To reduce SE taxes by paying a reasonable salary subject to FICA/Medicare and taking remaining profits as distributions (not subject to SE tax). This strategy becomes meaningful roughly when net profits consistently exceed $80,000–$ 100,000.

Q3. A married couple earns $150,000 QBI from an S-Corp (non-SSTB). What is their QBI deduction?

QBI deduction = $150,000 × 20% = **$ 30,000** (well below the MFJ $383,900 phaseout threshold; no wage limitation applies at this level).