When to Register Your Business
You have an idea for a service or product that will change the world. Or at least, change the world by solving a narrow problem in your niche of expertise. This idea has potential to become a full business, but does that mean you need to do all the necessary paperwork to register the business before you sign your first customer?
In general, registering and officially starting a business in the eyes of the state only makes sense when you expect to start incurring expenses in the enterprise. If this is a solo endeavor you do in your spare time using your existing tools, spending your time making it official and including the new enterprise into your annual tax return won’t provide much benefit.
Once you start getting serious and thinking about purchasing a premium URL or hiring a contractor to design your logo, setting up your business entity will allow you to easily and justifiably capture those expenses to offset your tax burden. Depending on the form you choose for your new entity, setting things up properly can also shield you from legal liability.
How much time and expense does it take to set things up with the IRS and state if you take the DIY approach? Results vary widely by state of course, but for registering with Montana and the IRS, the fees will total around $100 and you will spend 2-3 hours of time navigating the state and IRS websites and their questionnaires. If you hire a professional to do this on your behalf, you can expect to pay either their fixed rate for this type of work or their hourly rate for a similar amount of time you might spend doing this on your own.
When you open the state questionnaire, you may feel intimidated by the number of questions posed there. The good news is that the stakes are relatively low at this point. Do your best, and if the enterprise takes off, you can always hire a lawyer later to help you optimize this registration.
Legal Entities vs Tax Entities: What’s the Difference?
The question on the IRS and state websites that matters most is your entity formation. Your entity selection will have both legal and tax consequences for your business. This article will give you the basic characteristics, advantages, and disadvantages of each entity type.
Ignoring the uncommon entity types for now, your basic legal entity options are:
- Sole Practitioner/ Partnership (depending on whether you own this alone or if you jointly own the company with someone else)
- Limited Liability Company (LLC)
- Corporation
For tax purposes, your basic options are:
- Sole Practitioner/General Partnership
- S Corporation
- C Corporation
The way this works in practice is you will combine your legal entity type with the tax structure. For example, you might set your company up as an LLC taxed like a sole practitioner, otherwise known as a Single Member LLC. In this case, your tax reporting would happen on a Schedule C inside of your annual personal tax return—no separate tax return needed for the business. Similarly, you might set up your general partnership as an LLC. You would then file a partnership tax return (Form 1065) at tax time.
Quick Recommendation: The Best Entity Type for Most Startups
Before we dive deep into the detailed advantages and disadvantages of each entity type, here is the TLDR of entity selection. For the legal designation, most new businesses should choose LLC for simplicity and better tax outcomes. The exception to this is if they hope to get multiple outside investors early in the company’s life and want to simplify tax reporting for those investors.
If attracting several outside investors early in the project is your goal, a corporation might be a better option than LLC. Though be warned—you will have more compliance responsibilities at the business level as a corporation than you would if you were an LLC. A Corporation might also be the better option if you expect to grow then sell the business after five years and aim for the Qualified Small Business Stock designation for a tax-free exit.
After selecting a legal designation, you will choose your tax designation. If you want to keep things simple and don’t expect the business to make serious money for a while, choose an LLC taxed as a Sole Practitioner or Partnership. If you expect earnings will outpace your normal wage and you don’t mind running payroll and filing payroll tax from the outset of the business, then an LLC taxed as an S Corporation might be the better option. After taking the extra administrative costs associated with an S Corp into account, a general rule of thumb is that S Corps tend to be worthwhile once expected business income reaches around $60,000.
Sole Proprietor and General Partnership: The Default Entity
Minimal Setup, Maximum Risk
If you start a business and register nothing with the state, you are considered a sole practitioner or general partnership by default depending on whether this is a solo or jointly held company. This offers no legal protection or any distinction between you and your business. If your business gets sued, both you and your business are held liable. Whether you are personally to blame or an employee is at fault does not matter—you and your business are indistinguishable in the eyes of the law. You get none of the legal shelter provided by an LLC or corporation.
The only advantage to the sole practitioner or general partnership designation is that it requires nothing to set up. The disadvantage is that this designation gives you no benefit or shelter.
Before you offer anything to the public, whether that is a service or access to your products, you would be wise to fully register your business with both the IRS and state and operate it like a separate legal entity from yourself. Protecting yourself from unlimited liability tied to your business will cost a hundred bucks and a couple of hours on the state and IRS websites.
Paperwork is part of the game of running a business, and registering your business and choosing an entity type that provides you with legal shelter is paperwork that needs to get done.
Limited Liability Company (LLC): The Most Flexible Option
Legal Protection and How to Maintain It
Limited Liability Companies are the most common business type for a good reason. They are easy to set up, simple to maintain, and can provide legal shelter like a corporation. Assuming everything is in order with the business, this legal shelter limits the business liabilities up to the value of the business itself. If the LLC gets sued, the litigators can take everything in the entire business, but they can’t go beyond the business to take everything from the LLC’s owners too. Owner risk is limited to the value of their interest in the business.
To enjoy the legal shelters from this entity type, however, the business needs to actually operate as its own distinct entity that is separate from you. This means that it needs its own bank and credit card accounts (or at least a dedicated personal card that is only used for business purposes). It needs to look like a business with evidence to back up that claim, such as its own financial statements, meeting notes, separate and reasonably funded finances, etc.
If you co-mingle personal and business transactions in the same accounts and don’t treat this as a separate entity from yourself, a litigator can perform a stunt called “piercing the corporate veil” and assert that the business is not really separate from you. This ruins that legal protection you thought you had from the entity designation, and suddenly all your personal assets are available to target in a lawsuit.
Don’t fret if you accidentally use your business credit card a few times for personal transactions (we’ll get into how to remedy that in a future post), but don’t make a habit of it.
How Income Tax Works for LLCs
The tax treatment for an LLC is that of a passthrough entity, meaning that earnings generated at the LLC level get passed through to the members (LLC owners are called members). This passthrough treatment provides a nice advantage over C Corporations that get taxed twice on income generated by the business. Corporate earnings in C Corps get taxed once at the corporate level and the shareholders get taxed again when they receive dividends. Unlike C Corporations, distributions from an LLC are mostly ignored when calculating taxable income. The exception is when distributions create insufficient basis, which we’ll cover in another post.
The default tax designation for an LLC is to treat it like a sole proprietor or a general partnership depending on whether the LLC is owned by one or multiple members (while still maintaining the legal shelter provided by the LLC). If there is a single member in the LLC, that member reports the income or loss generated by the LLC on Form Schedule C directly within their personal tax return. Single-member LLCs are “disregarded” for tax purposes, meaning they do not file their own tax returns.
For LLCs owned by a partnership of multiple members, passthrough treatment operates from a functional standpoint via Form K-1. The members receive a Form K-1 from the LLC showing earnings or losses generated by the LLC. They then include that taxable income (or loss) shown on the K-1 into their personal tax returns.
A beautiful feature of an LLC taxed as a general partnership is that the partnership agreement can have any voting rights and distribution or profit/loss-sharing scheme the partners agree to as long as this agreement has real economic substance. This can be nice for partnerships that have partners with varying degrees of involvement in the company.
For example, if you have passive investment-only partners, you can specify they get none of the losses and the first cut of profit sharing in exchange for a lack of voting rights. If these passive partners have a minority interest anyways, they might be wary of investing into a business they don’t control. This gives them the peace of mind that the active, majority-owner partners won’t take their money now when times are tight then later squeeze them out when times get better.
Partnerships allow maximum flexibility in the agreement, where S Corporations and C Corporations are more rigid in their requirements.
S Corporations: Pay Less Tax
Key Tax Advantages of an S Corporation
S Corporations (S Corps) are an entity type that exists only for tax purposes and live in a magic realm between that of corporations and sole proprietors and partnerships. An S Corporation will have a legal entity designation of either LLC or corporation. The difference in S Corporations is the tax treatment and special requirements to maintain this treatment.
S Corporations are similar to general partnerships in that they receive passthrough income and only pay income tax at the shareholder level. The S Corporation itself does not owe any federal tax for income generated by the business. Like a general partnership, distributions are tax free.
The downside of S Corporation distributions is that they must strictly follow the ratio of shares held by each shareholder. No special distributions, waterfall payouts, or other creative distribution schemes you might find in general partnership agreements are allowed. If a shareholder owns 10 percent of the shares, that shareholder needs to get 10 percent of every distribution or else you risk blowing the S Corp status.
No special classes of shares are allowed either (e.g., Class A, Class B, preferred shares, etc.) to get around this requirement. While you can have voting and non-voting shares, each share needs to have equal dividend and distribution rights.
The main benefit S Corporations enjoy over general partnerships is that the owners do not have to pay self-employment tax on the income generated by the business. Owners who work in the business are treated like employees and need to take a wage similar to what they would pay an unrelated employee to do the same job. They pay regular payroll tax on those wages, but don’t have to pay self-employment tax on the business income beyond this wage. If earnings exceed this wage, this arrangement can save a significant amount of tax.
Self-employment tax is huge—at the time of writing it is 15.3 percent on the first $160,200 of income, 2.9 percent on the next band of income up to a threshold based on filing status ($250,000 for married filing jointly or $200,000 for single), and 3.8 percent on income over this threshold.
Compare an owner who could reasonably justify a wage of $75,000 but earns $250,000 total income in the business. As a single-filer, single-member LLC, this entire $250,000 of business earnings is subject to self-employment tax. Multiplied by the rates above at each income tier, this owner would pay $27,540 in self-employment tax.
If the owner instead paid themselves $75,000 as an employee inside of an S Corporation, the combined employer and employee portions of payroll tax would be $11,475. The difference in payroll tax between the two scenarios is $16,065.
The downside to this arrangement is that the business has to run payroll, file regular payroll tax returns with the IRS and state, issue W-2s, and do the regular paperwork associated with having employees. If the business is generating significant income, this extra paperwork is likely worth it. For companies just starting out that don’t make significant income yet, this extra paperwork might be enough of a hassle to choose a sole proprietor or general partnership tax designation at the outset.
You can always elect S Corporation tax status later once the business starts making significant money. If you expect to make a meaningful income right away, however, setting the business up as an S Corp from day one will simplify your filing and ensure the IRS has the correct entity designation from the outset.
S Corporation Requirements and Risks
Beyond the proportionate-distribution requirement mentioned above, companies must meet a handful of other requirements to maintain S Corporation status.
- Be a domestic (US-based) corporation
- Have only allowable shareholders:
- Eligible shareholders include individuals, certain trusts, and estates
- Ineligible shareholders include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Members of the same family are considered a single shareholder for this requirement which can significantly expand shareholder-count eligibility
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)
- All shareholders must agree for the corporation to elect and maintain S Corporation status
If an S Corporation violates one of these requirements, the S Corporation status can be revoked, turning the company into a C Corporation by default. Turning into a C Corporation means the entity will enter a separate tax realm where double-taxation gets enforced—once at the entity level and again on dividends at the shareholder level.
You want to be careful to avoid accidentally killing the S election and forcing the entity into a C Corporation. Or worse, you want to ensure one of your fellow shareholders cannot hold everyone over a barrel by threatening to violate the S election and throw everyone else into double-taxation if they don’t get what they want. There are ways you can set up the shareholder agreement to prevent these missteps, so ensure whoever you hire to write up that agreement has done this many times before and knows the appropriate provisions needed to prevent shareholder abuse or accidental revocation of the S election.
C Corporations: Built for Growth and Investment
Double Taxation and When It Makes Sense
The C Corporation (C Corp) entity type was mostly shunned by small to mid-sized business and reserved primarily large corporations that needed many shareholders to support the market cap requirements. The reason for the limited use among small and mid-sized businesses was that the 35 percent maximum tax rate combined with the double taxation at both the business and shareholder level was a tough pill to swallow.
Much of that changed with the 2017 Tax Cuts and Jobs Act (TCJA) that lowered the maximum C Corporation tax rate from 35 percent down to 21 percent. Suddenly, the federal total income tax owed by C Corporations and its shareholders was not as different from the tax owed by passthrough entities and their owners. Interest in this entity type piqued because C Corporations have some nice features compared to the passthrough entity types.
Federal Tax Comparison: S Corp vs C Corp
Let’s look at a simplified federal tax example where we ignore payroll tax, state tax, and wages. Assume a company has a single owner and earned $1 million during the year. The company plans to pay out the entire after-tax earnings to the owner. Assume further on the C Corporation side that the dividend qualifies as qualified dividend treatment.
- If this company was a C Corp, the company would pay Uncle Sam 21 percent of the earnings ($210,000). It can then pass the remaining $790,000 to the single shareholder who would pay a tax rate of 20 percent on the qualified dividend ($158,000). Total federal income tax paid by the C Corp and the sole owner is $368,000, or around 36.8 percent of the original earnings.
- If this company were an S Corp (with no wages for simplicity), the S corp would pay no tax at the entity level and could pass the entire $1 million to the sole shareholder. This shareholder would be in the top tax bracket at 37 percent and owe $370,000 of federal income tax on those passthrough earnings. The total federal tax paid is virtually the same as the C Corp scenario.
Risks of Choosing a C Corporation Too Early
A word of caution before moving forward. This 21 percent maximum C Corp tax rate is current as of the writing of this book in 2024. Congress has threatened to raise this rate closer to earlier levels multiple times since the 2017 TCJA was passed. There is a chance the rate goes back up during the lifetime of your business. While converting from other entity types to a C Corp is relatively simple, going the other direction becomes more complicated. Once you are a C Corp, it can be tough to go back to something else (such as an S Corp). Make sure you want and need the C Corp advantages below before checking the box to become a C Corp.
Another word of caution for the small-business taxpayer. Small businesses can sometimes qualify for the Qualified Business Income (QBI) deduction. The intricacies of this deduction are beyond this article, but in short, it provides a deduction to small businesses that effectively operates as a rate-reduction mechanism. The deduction would tip the scales to favor pass-through treatment over C corporation treatment as far as the effective tax rate is concerned. This deduction came into effect with the TJCA at the same time C corporations received a rate reduction. However, as of the writing of this article, the QBI deduction is scheduled to sunset on December 31, 2025.
Flexibility and Investor Readiness
The main advantage of a C Corporation comes from its independence from its shareholders. It pays its own tax, has its own corporate bylaws, its own governance, and operates like an independent person. While other entity types are technically separate from their owners too, the passthrough nature of taxable income for other entities muddies the waters a bit on the independence front.
This separation makes C Corporations far more convenient for acquiring new investors and shareholders. This includes issuing separate classes of shares (e.g., voting, nonvoting, preferred), operating across state and country lines without triggering reporting responsibilities for individual shareholders (though you still need to be careful about operating across countries), and it allows for virtually anyone or any entity to own shares without adverse consequences. Corporations have duties and responsibilities, so you still need to toe the line with this entity type, but the overall flexibility can be very attractive.
Corporations also have the potential to provide early company investors with a tax-free business sale, up to $10 million, if it is properly qualified and designated as a Qualified Small Business Stock and handled properly during the life of the corporation.
Conclusion
Deciding how to structure your business isn’t just a paperwork exercise—it’s a foundational move that can affect your taxes, legal exposure, ability to raise capital, and long-term exit strategy. While the default options may seem easier in the short term, taking the time to choose the right entity—and understanding the tax implications that come with it—can save you time, money, and stress as your company grows.
Whether you’re launching a venture on your own or bringing in investors for something bigger, aligning your legal and tax structure with your goals from day one gives you a strategic edge. And remember: your entity selection doesn’t have to be permanent. As your business evolves, your entity structure can evolve too.
Disclaimer: This article is for informational purposes only and is not intended as tax, legal, or financial advice. Always consult with a qualified professional about your specific situation. Reading this post does not create a CPA–client relationship.
Joe Holbrook is a CPA and Partner at Elevated Tax & Accounting. Joe’s career has focused on helping business owners pay less tax and improve cash flow, serving companies ranging from small, local businesses, Fortune 500 companies, and everything in between. He also supports nonprofits fulfill their missions through financial excellence, given the highly active nonprofit environment surrounding Elevated’s office in beautiful Missoula, Montana.
