Choosing an entity: sole proprietorship, S corporation or C corporation

The choice of entity is one of the most consequential tax decisions a business owner makes, and it is not made once: owners revisit it as the business grows, takes on investors or approaches a sale. This lesson brings together the rules from lessons 1 to 4 and compares the three main choices for the Brandts' business, using their actual 2027 numbers: operating as a sole proprietorship (or single-member LLC), electing S corporation status and paying Leah a salary, or operating as a C corporation. It then examines the factors that decide the comparison in practice: payroll and self-employment taxes, the qualified business income deduction, reasonable compensation, fringe benefits and retirement plans, retention of profits, and the expected exit.

The building blocks of the comparison

Four sets of rules drive the comparison. First, self-employment tax: a sole proprietor or active partner pays 15.3 percent on 92.35 percent of net earnings up to the $184,500 Social Security wage base for 2026, and 2.9 percent above it. Second, payroll tax: an S or C corporation pays its owner-employee a salary on which the corporation and the employee each pay 7.65 percent, but distributions of S corporation profit and dividends from a C corporation bear no employment tax. Third, the qualified business income deduction of 20 percent applies to a sole proprietor's net profit and to S corporation and partnership income, but not to wages, guaranteed payments or C corporation dividends. Fourth, the C corporation pays 21 percent and its shareholders pay tax again on dividends, while flow-through income is taxed once at the owners' rates.

The Brandts' comparison

The program computes the Brandts' total federal tax for 2027 under each structure, using the business income determined in lesson 2 before any payment to Leah, $170,191, and 2026 rates. Tomás's wages of $38,000 and the standard deduction and child tax credit are the same in every case. For the S and C corporations, Leah is paid a $70,000 salary. The C corporation is assumed to pay out all of its after-tax profit as qualified dividends, which is the worst case for it; the investment income in the corporation is left out to keep the comparison clean. The final lines vary Leah's S corporation salary.

# Sole proprietorship, S corporation or C corporation? The Brandts' 2027 federal tax using
# 2026 rules, married filing jointly (illustrative). Tomas earns $38,000 of wages.
BR = [(24_800, 0.10), (100_800, 0.12), (211_400, 0.22), (403_550, 0.24),
      (512_450, 0.32), (768_700, 0.35), (float('inf'), 0.37)]
PRE_PAY = 170_191              # active business income before paying Leah anything
TOMAS, STD, CTC = 38_000, 32_200, 2_200

def bracket(x):
    tax, lo = 0.0, 0.0
    for hi, r in BR:
        if x > lo:
            tax += (min(x, hi) - lo) * r
        lo = hi
    return tax

def qualified_div_tax(ordinary_taxable, qd):
    zero = max(0.0, min(qd, 98_900 - ordinary_taxable))
    return 0.15 * (qd - zero)                      # 20% band starts far higher

def sole_prop():
    se = 0.153 * 0.9235 * PRE_PAY                  # below the $184,500 wage base
    agi = TOMAS + PRE_PAY - se / 2
    qbi = 0.20 * (PRE_PAY - se / 2)
    income_tax = bracket(agi - STD - qbi) - CTC
    return {"income tax": income_tax, "payroll/SE tax": se, "corporate tax": 0.0}

def s_corp(salary=70_000):
    fica = 0.153 * salary                          # employee 7.65% + employer 7.65%
    k1 = PRE_PAY - salary - fica / 2
    qbi = 0.20 * k1
    income_tax = bracket(TOMAS + salary + k1 - STD - qbi) - CTC
    return {"income tax": income_tax, "payroll/SE tax": fica, "corporate tax": 0.0}

def c_corp(salary=70_000):
    fica = 0.153 * salary
    corp_income = PRE_PAY - salary - fica / 2
    corp_tax = 0.21 * corp_income
    dividend = corp_income - corp_tax              # all paid out as qualified dividends
    ordinary = TOMAS + salary - STD
    income_tax = bracket(ordinary) + qualified_div_tax(ordinary, dividend) - CTC
    return {"income tax": income_tax, "payroll/SE tax": fica, "corporate tax": corp_tax}

for name, f in (("Sole proprietorship (Schedule C)", sole_prop),
                ("S corporation, $70,000 salary", s_corp),
                ("C corporation, $70,000 salary, rest paid out", c_corp)):
    r = f()
    total = sum(r.values())
    print(f"{name:<46} income {r['income tax']:>9,.0f}  payroll/SE {r['payroll/SE tax']:>7,.0f}"
          f"  corporate {r['corporate tax']:>7,.0f}  total {total:>8,.0f}")
print()
for salary in (50_000, 70_000, 100_000, 140_000):
    print(f"S corporation salary {salary:>8,}: total federal tax {sum(s_corp(salary).values()):>9,.0f}")

Sole proprietorship (Schedule C)               income    16,337  payroll/SE  24,047  corporate       0  total   40,385
S corporation, $70,000 salary                  income    20,591  payroll/SE  10,710  corporate       0  total   31,301
C corporation, $70,000 salary, rest paid out   income    14,173  payroll/SE  10,710  corporate  19,916  total   44,799

S corporation salary   50,000: total federal tax    27,630
S corporation salary   70,000: total federal tax    31,301
S corporation salary  100,000: total federal tax    36,807
S corporation salary  140,000: total federal tax    44,149

The S corporation is clearly cheapest: $31,301 of federal tax, against $40,385 for the sole proprietorship and $44,799 for the C corporation that pays out its profits. The S corporation saves $13,337 of employment taxes compared with the proprietorship, because only the $70,000 salary bears FICA ($10,710) instead of self-employment tax on all of the profit ($24,047), partly offset by higher income tax because the QBI deduction no longer applies to the salary portion. The C corporation is most expensive because the dividends are taxed again, although at only 15 percent. The final lines show how sensitive the S corporation result is to Leah's salary: each extra $10,000 of salary costs about $1,800 of tax. The temptation is to pay a very low salary, which is exactly what the reasonable compensation rules address.

Reasonable compensation

An S corporation shareholder who performs more than minor services for the corporation must be paid reasonable compensation before receiving non-wage distributions. The Code does not say so directly; the IRS relies on the definition of wages in the employment tax provisions, Revenue Ruling 74-44 and a long line of cases that recharacterize distributions as wages when the salary is unreasonably low. The leading modern case, David E. Watson, P.C. v. United States (8th Cir. 2012), involved an Iowa accountant who paid himself $24,000 a year through his S corporation while taking much larger distributions; the court upheld the IRS's finding that about $91,000 was reasonable. Factors include training and experience, duties and responsibilities, time devoted to the business, what comparable businesses pay for similar services, and the proportion of revenue generated by the owner's personal services. A salary supported by market data and documented annually is the best defense.

QBI, fringe benefits and retirement plans

Several other differences matter. The QBI deduction is 20 percent of qualified business income, limited to 20 percent of taxable income minus net capital gain. Above a threshold ($201,750 single, $403,500 joint for 2026), the deduction is limited by W-2 wages paid by the business and the basis of its depreciable property, phased in over $75,000 ($150,000 joint) under the 2025 act's wider ranges, and income from specified service trades or businesses, such as health, law, consulting and financial services, is phased out entirely. Fringe benefits favor the C corporation: a shareholder owning more than 2 percent of an S corporation is treated like a partner, so health insurance premiums paid for him are added to W-2 wages (though deductible on his return as self-employed health insurance) and he cannot use a cafeteria plan. Retirement plans favor paying wages: 401(k) deferrals, $24,500 for 2026, and employer contributions in an S or C corporation are based on W-2 wages, while a sole proprietor's contributions are based on net self-employment earnings.

Retaining profits and planning the exit

The comparison changes if profits are retained rather than paid out. A C corporation keeping $100 of profit pays $21, while an S corporation's owners in the 24 percent bracket pay $24 less the QBI deduction's effect, about $19.20, plus nothing on retention; the difference is small at middle incomes but grows for owners in the 35 or 37 percent brackets. The exit also matters. A buyer usually wants to buy assets and get a stepped-up basis; an S corporation's asset sale is taxed once to the shareholders, while a C corporation's asset sale is taxed to the corporation and again when the proceeds are distributed, as lesson 6 shows. A C corporation whose stock qualifies under section 1202 can be sold with the gain partly or wholly excluded. Converting from C to S status later is possible but triggers the built-in gains tax on appreciation present at conversion if assets are sold within five years (lesson 8), while revoking S status bars a new election for five years.

Two other differences complete the comparison. First, the net investment income tax of 3.8 percent applies to C corporation dividends received by shareholders with modified AGI above $250,000 (joint) but not to S corporation or partnership business income of owners who materially participate, which widens the gap for high-income owners. Second, state taxes vary: a C corporation pays state corporate income tax, which it can deduct federally, and its shareholders pay state tax again on dividends; an S corporation's income is taxed once at the owners' state rates, and an elective pass-through entity tax can make that state tax deductible federally, as lesson 9 explains. A few states, such as New York City and California, impose entity-level taxes on S corporations that reduce the advantage, and a few, such as Tennessee and Texas, tax LLCs and S corporations at the entity level under franchise or margin taxes. Because Iowa offers a PTET and taxes individuals at a flat 3.8 percent, the state picture reinforces the S corporation choice for the Brandts. Finally, all of these comparisons are sensitive to the facts: a much more profitable business, a plan to sell within a few years, or outside investors could change the answer, so the choice should be revisited as the business grows.