Understanding Tax Structure and Legal Entity Structure for Small Businesses and Freelancers

The other day, I was at a coffee shop when I overheard two finance students discussing LLCs. One of them confidently stated, "LLCs are automatically taxed as separate entities." I couldn’t help but chime in. I explained that LLCs aren’t taxed separately by default—they’re pass-through entities unless they elect a different tax classification. That conversation made me realize how many small business owners and freelancers might have similar misconceptions. So, let’s break down tax structures and legal entity options in a way that’s easy to understand.

Common Legal Structures

When starting a business, choosing the right legal entity structure is crucial.

A sole proprietorship is the simplest setup—there’s no separation between you and your business. This means your personal assets are at risk, and all business income is reported on your personal tax return.

An LLC (Limited Liability Company) offers more flexibility. It provides liability protection while keeping taxes simple. By default, a single-member LLC is taxed like a sole proprietorship, while a multi-member LLC is treated like a partnership. However, LLCs can choose to be taxed as an S-Corp or C-Corp for different benefits.

An S Corporation (S-Corp) is not a separate legal entity but a tax designation. It allows business owners to avoid self-employment tax on some of their earnings by paying themselves a reasonable salary and taking the rest as distributions.

A C Corporation (C-Corp), on the other hand, is a completely separate legal and tax entity. While this structure is great for businesses looking to attract investors, it comes with the downside of double taxation—once at the corporate level and again on shareholder dividends.

A partnership is for businesses with multiple owners. Like an LLC, it’s a pass-through entity, meaning profits are reported on each partner’s personal tax return. However, partners are responsible for self-employment taxes on their earnings.

Tax Implications of Each Structure

Taxes vary depending on your business structure. A sole proprietorship and default LLCs are taxed through the owner’s personal return and subject to self-employment tax. Partnerships operate similarly, with income passing through to partners.

An S-Corp allows owners to take part of their earnings as distributions, which aren’t subject to self-employment tax. A C-Corp, while taxed at a corporate level, also requires shareholders to pay taxes on dividends received.

Choosing the Right Structure

If protecting personal assets is a priority, forming an LLC or corporation makes sense. If minimizing self-employment tax is a goal, electing S-Corp status could be beneficial. Planning to seek investors? A C-Corp might be the right choice. But if you want a simple, no-fuss setup, a sole proprietorship or default LLC may be enough.

It’s also important to consider how much paperwork and compliance each structure requires. Sole proprietorships and LLCs have fewer regulations, whereas corporations have more administrative requirements.

Steps to Register and Set Up Taxes

Once you've chosen your structure, the next steps involve making it official. You’ll need to register your business with your state and obtain an EIN (Employer Identification Number) from the IRS.

A business bank account helps keep finances separate. You may also need to decide if electing a different tax classification, such as S-Corp status, is beneficial. Lastly, don’t forget about estimated quarterly tax payments if required.

Understanding tax and legal structures is vital for small business owners and freelancers. The right choice can impact liability, taxes, and long-term success. If you’re unsure, consulting a tax professional can help you navigate the complexities and make the best decision for your business.

That coffee shop conversation reminded me that tax misconceptions are common—but with the right knowledge, business owners can make smarter, more strategic choices.

As always, we hope you’ve learned something valuable today, and when the time comes, we hope you’ll choose Stack to be part of your success story! -Stack Insights