The Tax Trap Hiding in Your Business Structure

Why your business structure quietly rewrites your tax bill

Most people pick a structure because a friend did, or because an online form made it look easy. “Just start as a sole prop, you can change later.” That sounds reasonable, but it’s actually a tax strategy — just an unplanned one.

Here’s the uncomfortable truth: once money starts flowing, switching structures gets messy. You’re suddenly dealing with capital accounts, built‑in gains, maybe even double taxation if you picked a C corporation without really meaning to.

So before we dive into each type, keep three questions in the back of your mind:

• Who pays tax: the business, you personally, or both?
• How is the profit labeled: wages, self‑employment income, dividends, distributions?
• How flexible is this structure if your profits double… or your losses do?

If you can answer those three, you’re already ahead of most new founders.

Sole proprietorship: the “I’ll just start and see what happens” option

A lot of people don’t even realize they’re sole proprietors. You start freelancing, doing consulting on the side, selling products online — congratulations, you basically created a sole proprietorship by default.

How the IRS sees you

For tax purposes, you and the business are the same person. There’s no separate business tax return. You report all income and expenses on Schedule C of your personal Form 1040.

That sounds simple, and in many ways it is. But simplicity comes with a price.

• All net profit is subject to income tax and self‑employment tax (Social Security and Medicare).
• You don’t get a salary vs. distribution split. If the business earns \(120,000 and you spend \)60,000 of it, the full $120,000 is still your taxable business profit.

Take Maya, a designer pulling in \(150,000 in revenue with \)50,000 in expenses. Her $100,000 profit is:

• Taxed at her personal income tax rate, and
• Hit with self‑employment tax of roughly 15.3% on most of that amount.

It’s straightforward, but not always kind.

Where a sole proprietorship actually works

It’s not always a bad idea. For small side gigs or early‑stage experiments, it’s:

• Easy to start
• Cheap to maintain
• Simple to report

But once you’re earning a full‑time income, you’re paying self‑employment tax on every dollar of profit. At that point, you start looking at LLCs and S corporations with a bit more interest.

If you want to dig into the IRS view of this, their guidance on self‑employment tax is surprisingly readable: irs.gov/businesses/small-businesses-self-employed.

Partnerships: shared profit, shared tax headaches

The moment two or more people go into business together without forming a corporation, they’ve basically created a partnership. Even if they never signed a fancy agreement. The tax code doesn’t wait for your lawyer to catch up.

How profits and losses flow through

A partnership files an informational return (Form 1065), but the entity itself generally doesn’t pay income tax. Instead:

• The partnership calculates total profit or loss.
• That result is divided among the partners based on their agreement.
• Each partner gets a Schedule K‑1 showing their share.
• Partners report their share on their personal returns and pay the tax.

Here’s the twist that surprises people: you can be taxed on income you never actually received in cash. If the partnership leaves profit in the business, you still report your share as taxable income.

Take Jordan and Lee, 50/50 partners in a marketing agency. The firm earns \(200,000 after expenses but only distributes \)80,000 in cash because they want to keep money in the business.

• Each partner is taxed on $100,000 of income.
• Each partner only received $40,000 in cash.

You can see how that gets uncomfortable fast.

Self‑employment tax and active partners

For most active partners, their share of business profit is also subject to self‑employment tax, similar to a sole proprietorship. There are some technical exceptions for limited partners in certain types of partnerships, but if you’re working in the business, assume the IRS wants its Social Security and Medicare cut.

The IRS has a whole section on partnerships here: irs.gov/businesses/partnerships.

LLCs: flexible shell, but the tax treatment is a choice

“Just form an LLC” is the standard startup advice. And to be fair, from a legal‑liability point of view, it’s often smart. But an LLC is a legal structure, not a fixed tax identity.

The tax code basically asks your LLC: “So what do you want to be when you grow up?”

Default tax treatment

By default:

• A single‑member LLC is ignored for tax purposes and treated like a sole proprietorship.
• A multi‑member LLC is treated as a partnership.

So if you stop there, all the tax rules we just covered still apply. The big difference is liability protection, not taxation.

Electing to be taxed as an S corporation or C corporation

Here’s where it gets interesting. An LLC can elect to be taxed as:

• An S corporation (using Form 2553), or
• A C corporation (using Form 8832).

That means the same legal LLC can wear different tax “costumes.” This is often where serious tax planning begins.

Take Sam, a software developer making \(220,000 in profit through a single‑member LLC. As a default disregarded entity, that \)220,000 is all subject to self‑employment tax. If Sam elects S corporation status and pays himself a reasonable salary of, say, \(130,000, only that salary is hit with payroll taxes. The remaining \)90,000 may be treated as distributions not subject to self‑employment tax.

Is it free money? No. The IRS expects that salary to be truly reasonable for the role. But with good documentation, the savings can be very real.

The flexibility of an LLC is great, but it also means you can accidentally stay in a tax treatment that no longer fits your income level.

S corporations: the “can I pay myself less tax?” structure

S corporations live in that gray zone entrepreneurs love: still a pass‑through entity (no corporate‑level income tax in most cases), but with some wiggle room on self‑employment taxes.

How S corporation taxation actually works

An S corporation:

• Files its own tax return (Form 1120‑S).
• Passes profit and loss through to shareholders via Schedule K‑1.
• Generally doesn’t pay federal income tax at the corporate level.

The big tax angle is how owners get paid:

• You must pay yourself a reasonable salary if you work in the business.
• That salary is subject to payroll taxes (Social Security and Medicare), just like any employee.
• Profit above that salary can be distributed as dividends/distributions that are not subject to self‑employment tax.

Back to Sam, our developer. If the S corporation earns \(220,000 and pays Sam a \)130,000 salary:

• $130,000 is hit with payroll taxes.
• $90,000 may avoid self‑employment tax.

Income tax still applies to the full amount, but reducing payroll/self‑employment tax can save thousands.

Where S corporations shine — and where they don’t

They tend to work well when:

• The business is consistently profitable.
• Owners actively work in the business.
• There’s enough profit above a reasonable salary to justify extra admin costs.

They’re less attractive when:

• Income is low or volatile.
• You don’t want the complexity of running payroll and separate corporate formalities.

The IRS has a detailed Q&A on S corporations here: irs.gov/businesses/small-businesses-self-employed/s-corporations.

C corporations: double tax, but also big‑league options

C corporations get a bad reputation among small business owners because of one phrase: double taxation. And yes, it’s real.

What double taxation actually means

Here’s the sequence:

• The corporation pays tax on its profits at the corporate tax rate.
• If it then distributes those after‑tax profits as dividends, shareholders pay tax again on those dividends.

So the same dollar of profit gets taxed at the corporate level and then again at the shareholder level.

Sounds ugly, right? Yet almost every large company you know is a C corporation. So why do people still choose it?

When a C corporation makes sense

C corporations become interesting when:

• You plan to reinvest most profits back into the business instead of distributing them.
• You want to raise significant capital from venture capital or institutional investors.
• You may eventually go public or sell the company.

The flat corporate tax rate can be attractive in certain income ranges, and there are special provisions (like Section 1202 qualified small business stock in the US) that can dramatically reduce tax on gains if you meet certain conditions and hold the stock long enough.

But if you’re running a small consulting firm and pulling most of the profit out each year? A C corporation can be a tax headache you don’t need.

The IRS overview is here: irs.gov/businesses/corporations.

The self‑employment tax question nobody really explains

Income tax gets all the attention, but for many small business owners, self‑employment tax and payroll taxes are where the real pain sits.

Here’s the rough landscape:

• Sole proprietors and most partners: pay self‑employment tax on net earnings.
• Single‑member LLCs (default): same as sole proprietors.
• Multi‑member LLCs (default): usually same as partnerships.
• S corporation shareholders who work in the business: pay payroll tax on salary only.
• C corporation owners: pay payroll tax on wages, no self‑employment tax on dividends.

This is why you hear so many people talking about “reasonable salary” and S corporations. They’re really trying to manage payroll/self‑employment taxes, not just income tax.

But pushing that too far — paying yourself a suspiciously low salary — is a good way to get the wrong kind of IRS attention.

The pass‑through deduction: a temporary bonus with strings attached

In the US, many small businesses got a new twist in the tax story: the Qualified Business Income (QBI) deduction under Section 199A.

In plain English, many owners of pass‑through entities (sole props, partnerships, S corps, some LLCs) may be able to deduct up to 20% of their qualified business income, subject to a maze of limits.

It’s not automatic, and it phases out for certain high‑earning service businesses (think law, medicine, consulting) once income crosses set thresholds.

Why mention it here? Because your choice of structure affects:

• Whether you qualify,
• How much you can deduct,
• And how complex the calculation becomes.

The IRS has a detailed FAQ on this: irs.gov/newsroom/qualified-business-income-deduction.

If you’re anywhere near the income thresholds, this is not something to casually DIY.

Real‑world pivots: when founders actually switch structures

It’s one thing to talk theory. It’s more interesting to look at how people actually move through these structures over time.

Take Alex, who started tutoring online during grad school. At first, it was just a few hundred dollars a month. A sole proprietorship made perfect sense — quick, cheap, and easy.

Within three years, Alex was making $140,000 a year and had hired two part‑time tutors. Suddenly, that Schedule C self‑employment tax bill was… painful. After talking with a CPA, Alex formed an LLC and elected S corporation status, set up payroll, and split income between salary and distributions. Same business, same clients, very different tax profile.

Then there’s Priya and Omar, co‑founders of a small manufacturing startup. They began as an LLC taxed as a partnership. Once investors got involved, everyone pushed toward a C corporation structure to match investor expectations and stock‑option plans. Their personal tax situation got more complex, but it aligned with their long‑term goal: a possible acquisition.

These shifts aren’t rare. They’re actually pretty common once revenue, investors, or headcount grow. The mistake is assuming you’ll “just cross that bridge later” without realizing that crossing sometimes means legal fees, tax planning, and a lot of paperwork to clean up past decisions.

How to think about your choice without losing your mind

If you’re feeling that mix of “this is interesting” and “this is way too much,” that’s actually pretty normal.

A practical way to approach it:

• If you’re testing an idea with tiny revenue and low risk, a sole proprietorship or simple single‑member LLC can be fine.
• Once you’re making a steady, full‑time income, it’s worth running the numbers on an S corporation election, especially if you’re in the US and expect consistent profit.
• If you’re raising outside capital or dreaming of going public, you’re probably heading toward a C corporation whether you like it or not.

And through all of this, remember: liability and taxation are different questions. LLCs are often about protecting your personal assets. S corp vs. C corp vs. partnership is often about how the IRS slices your pie.

The smart move is to treat this like any other serious business decision: model a few scenarios, ask uncomfortable questions, and get someone who lives in this world every day to sanity‑check your plan.

FAQ: the awkward questions founders actually ask

Do I pay more tax as a corporation than as an LLC?

“LLC” is mostly a legal label. For tax, the real question is whether you’re taxed as a sole proprietor, partnership, S corporation, or C corporation. An LLC can be any of those. So you don’t compare “LLC vs. corporation”; you compare how each tax regime treats your income, payroll, and distributions.

Can I start as a sole proprietor and switch later without problems?

You can start that way, and many people do. But “without problems” is optimistic. Once you have assets, contracts, or partners, moving them into a new entity needs to be done carefully to avoid tax surprises and legal gaps. It’s doable, just not as casual as people make it sound.

Is an S corporation always better for taxes than a sole proprietorship?

No. If your profit is modest or inconsistent, the extra cost of payroll, bookkeeping, and tax prep can eat up the savings. S corporations tend to make more sense once your profit is comfortably above what a reasonable salary would be for your role.

Do I really need a CPA, or can I figure this out with software?

Tax software is great at filling in forms. It’s not great at telling you whether you picked the right structure three years ago. If your business is more than a small side hustle, talking to a CPA or enrolled agent who understands small business is usually money well spent.

Are the rules the same in every country?

Not even close. This article leans heavily on the US system. Other countries have their own versions of corporations, partnerships, and self‑employment taxes, but the details can be wildly different. If you operate internationally, you’re playing on hard mode and need local advice in each jurisdiction.

If there’s one takeaway, it’s this: your business structure is not just a legal formality. It’s a tax story you’re writing about your income, your risk, and your future exit — whether you meant to write it or not.