Choosing the Right Business Entity

The way your business is set up decides how much of every dollar of profit you keep, both while you run it and when you sell it

Case Study Summary

How the Right Entity Choice Could Save a Business Owner $12,500 a Year Today and $3.57 Million When They Sell

By switching to an S corporation, they cut their payroll taxes every year. By building the right company as a C corporation, they could sell it with no federal tax on up to $15 million of gain

Background: Why Does Your Business Entity Matter?

Most business owners pick their entity once, when they start the business.

Usually it’s whatever their accountant or an online form suggested at the time.

And they never think about it again.

But the entity you choose controls three big things:

1. How much payroll tax you pay on your profits
2. What tax rate applies to the profits you keep in the business
3. How much tax you pay when you sell

The right choice when you were making $50,000 a year is often the wrong choice when you’re making $500,000.

So which entity is right for you?

And the answer depends on what you want the business to do for you.

What Are the Main Options?

There are three entities most business owners choose between:

• Sole proprietorship or single-member LLC. The simplest setup. All of your profit is subject to self-employment tax.
• S corporation. You pay yourself a reasonable salary, which is subject to payroll taxes. The rest of your profit comes out as a distribution, which isn’t.
• C corporation. The business pays its own tax at a flat 21%. Profits paid out to you as dividends are taxed again.

Let’s look at when each one makes sense.

When Does an S Corporation Save Money?

As a sole proprietor, all of your profit is hit with self-employment tax: 15.3% on the first $184,500 in 2026, and 2.9% on everything above it.

An S corporation lets you split your profit into two pieces. Only the salary piece pays payroll tax.

Let’s look at a quick example.

Let’s say your business makes $300,000 a year, and a reasonable salary for your role is $120,000.

Payroll Taxes as a Sole Proprietor vs. an S Corporation

The S corporation saves about $12,500 a year in payroll taxes on the same profit.

(Sole proprietors pay self-employment tax on 92.35% of profit, which is where the $277,050 comes from.)

But this is where a lot of business owners get oversold.

The savings are real, but they’re capped. Once your salary is above the $184,500 Social Security limit, the savings shrink to just the 2.9% Medicare tax. And an S corporation comes with its own costs: payroll, a separate tax return, and more bookkeeping.

There are two more catches:

• Your salary has to be reasonable. Pay yourself too little and the IRS can reclassify your distributions as wages.
• A lower salary means lower retirement contributions. As we covered in “Maximizing Tax Deferral for Business Owners,” 401(k) and cash balance plan contributions are based on your W-2 salary. Cutting your salary to save payroll tax can cost you a much larger retirement plan deduction.

When Does a C Corporation Make Sense?

A C corporation pays a flat 21% federal tax on its profits.

If you’re in the top 37% federal bracket, that’s a big difference, as long as the money stays in the business.

The problem comes when you take the money out. Dividends are taxed again, at up to 23.8%.

Federal Tax on $1 Million of Profit by Entity

A C corporation wins when profits stay in the business to grow it. It loses when profits are paid out to you every year.

That’s why a C corporation fits founders who are reinvesting to build something to sell, not owners who live on the business’s profits.

What Happens When You Sell a C Corporation?

This is where the C corporation can be the most powerful entity of all.

Stock in a qualifying C corporation can be “qualified small business stock” (QSBS). When you sell it, some or all of the gain can be excluded from federal tax entirely.

For stock issued after July 4, 2025:

• Hold it 3 years and 50% of the gain is excluded.
• Hold it 4 years and 75% is excluded.
• Hold it 5 years and 100% is excluded.

The exclusion covers up to $15 million of gain, or 10 times what you invested, whichever is greater.

Federal Tax on a $15 Million Business Sale

Holding QSBS for 5 years turns a $3.57 million federal tax bill into nothing.

But not every company qualifies. The company’s assets can’t exceed $75 million when the stock is issued, and it has to be an active business. Many service businesses don’t qualify at all, including health, law, consulting, and financial services.

Can I Change My Entity Later?

Yes. Many owners start as an LLC, elect S corporation status once profits grow, and convert to a C corporation when they’re building to sell.

But timing matters. The QSBS holding period only starts when you get the C corporation stock, and switching entities can trigger its own tax costs. So it pays to plan for your exit years before you get there.

Is Choosing the Right Entity a Tax-Strategy For You?

This strategy tends to matter most for:

• Sole proprietors and single-member LLCs earning steady profits above a reasonable salary
• S corporation owners who haven’t reviewed their salary in years
• Founders planning to grow and sell their company
• Owners who are reinvesting most of their profits back into the business

Who This Strategy Is Best For

• ✓Sole proprietors and single-member LLCs earning steady profits above a reasonable salary
• ✓Business owners who have never reviewed their entity structure
• ✓Founders planning to grow and sell their company
• ✓Business owners considering an eventual sale or exit
• ✓Self-employed professionals paying significant self-employment tax