By: Isla Carmichael

Why Entity Selection Is One of the Important Tax Decisions

Choosing your business entity is not just a legal formality. It can influence how your business is taxed, how you pay yourself, what deductions you qualify for, and how much of your income is subject to payroll and self-employment taxes. The right choice may help reduce taxes significantly, while the wrong choice could lead to higher taxes and unnecessary complications. In 2025, entity rules remain a key factor in tax planning for small business owners, freelancers, real estate operators, and consultants.

Understanding how each entity works can help you choose the most efficient structure for your goals.

Sole Proprietorship: Simple but High Tax Burden

A sole proprietorship is the default structure when you operate without a formal entity. While simple, it also comes with:

• Full self-employment tax

• Limited liability protection

• Limited flexibility

• Higher audit risk

Sole proprietors pay self-employment tax on all profits. This can be costly once income increases.

LLC: Liability Protection with Flexible Tax Options

An LLC provides legal protection and can be taxed in several different ways:

• As a sole proprietorship

• As a partnership

• As an S corporation

• As a C corporation

For most small businesses, an LLC taxed as an S corporation may offer the optimal blend of protection and tax savings.

Partnership: Ideal for Multi-Owner Businesses

Partnerships are ideal for businesses with more than one owner. They allow:

• Flexible ownership

• Pass-through taxation

• Expense allocation

• Profit distribution options

However, partnerships often require advanced tax planning to avoid unnecessary self-employment tax and to manage capital accounts correctly.

S Corporation: The Most Popular Tax-Saving Structure

S corporations remain the preferred tax-saving structure for many business owners. The key advantage is payroll control. Owners must pay themselves a reasonable wage, but profit distributions are not subject to self-employment tax. This may reduce taxes significantly.

Benefits include:

• Lower payroll tax

• QBI eligibility

• Pass-through taxation

• Liability protection via LLC conversion

However, proper payroll planning is essential to remain compliant.

C Corporation: Powerful for Specific Situations

C corporations are less common for small businesses, but they offer specific advantages:

• Flat corporate tax rate

• Deductible fringe benefits

• Potential for reinvestment

• More flexibility for employee benefits

However, C corporations may face double taxation if income is paid out as dividends. They are most effective for businesses that reinvest profits rather than distribute them.

How Income Affects Entity Selection

Income level influences which entity provides the most tax savings. For example:

• Under 60k profit: LLC taxed as sole proprietor may be fine

• 60k to 150k profit: S corporation provides strong payroll tax savings

• 150k to 500k profit: Advanced S corporation planning could become valuable

• 500k plus profit: C corporation or multiple-entity planning might be considered

Your advisor evaluates your projected income, not just current income.

How Payroll Influences Tax Savings

Payroll is central to entity planning. The goal is to balance:

• Reasonable compensation

• Distributions

• Tax brackets

• QBI eligibility

Overpaying yourself could increase tax unnecessarily. Underpaying may create IRS scrutiny. A strategic payroll plan can maximize savings.

Understanding QBI and Entity Structure

The Qualified Business Income deduction interacts differently with each entity. S corporations, partnerships, and sole proprietorships may all qualify depending on:

• Taxable income

• W2 wage amounts

• Qualified property

• Industry type

Choosing the wrong entity could reduce or eliminate your QBI deduction.

How Real Estate Businesses Should Choose an Entity

Real estate ownership and operations have unique considerations:

• Short-term rentals

• Long-term rentals

• Flips

• Real estate agent income

• Property management income

Most rental properties may benefit from simple pass-through treatment. Short-term rentals could qualify as active businesses and require more planning.

Avoiding Common Entity Mistakes

Many business owners choose an entity without understanding the tax impact. Common errors include:

• Setting up an S corporation too early

• Choosing a C corporation without a reinvestment strategy

• Failing to file the S corporation election on time

• Ignoring payroll requirements

• Mixing personal and business finances

• Not updating the entity structure as income grows

These mistakes may create unnecessary tax burdens and compliance issues.

The Importance of Year-Round Entity Planning

Entity selection is not a one-time decision. As your business grows, your entity might need to change. Year-round planning helps you:

• Adjust payroll

• Plan for QBI

• Evaluate income shifts

• Expand into new states

• Improve documentation

• Prepare for new tax laws

Your advisor should revisit the entity structure annually.

How AE Tax Advisors Helps You Choose the Right Entity

AE Tax Advisors provides comprehensive guidance by:

• Reviewing income and expenses

• Analyzing industry classification

• Evaluating payroll strategy

• Estimating tax savings for each entity

• Making filing elections

• Structuring multi-entity setups

• Ensuring compliance with IRS rules

The goal is to create the most tax-efficient structure based on your goals and your stage of business.

Final Thoughts

Choosing the right entity is one of the most impactful tax decisions you will ever make. Whether you are starting a new business or updating your structure for 2025, the right choice can reduce taxes significantly while providing legal protection and long-term flexibility. With the right advisor, entity planning may become a powerful tool for financial growth.

For high-income individuals who want a strategic partner steering their tax planning, more information is available at AETaxAdvisors.com.

Disclaimer: The information provided in this article is for general informational purposes only and should not be construed as legal or tax advice. Entity selection and tax planning are complex and individual circumstances may vary. It is recommended to consult with a qualified tax professional or legal advisor to evaluate your specific situation and make informed decisions based on your goals and needs. The content in this article is not a substitute for personalized advice and does not guarantee any specific tax outcome.