When starting a business, most entrepreneurs focus on choosing the proper legal structure, such as an LLC or corporation, through their state’s Secretary of State. However, another equally important layer is often overlooked: your business’s tax identity. While your legal structure determines how your business operates in the eyes of the law, your tax identity determines how the IRS sees you when it’s time to file returns and pay taxes.
For small business owners, three common tax identities are the Sole Proprietorship, S-Corporation, and C-Corporation. Each comes with its own set of advantages and drawbacks. Here’s a breakdown to help you better understand which might be the right fit for you.
Sole Proprietorship: The Simple Start
Pros:
If simplicity is what you’re after, the Sole Proprietorship is the easiest and most cost-effective route. There’s no separate business tax return—your income and expenses are reported directly on your Form 1040 via Schedule C. No separate business filings mean fewer headaches and lower costs.
Cons:
However, that simplicity comes at a cost. All your net income is subject to self-employment tax, including the employer and employee portions of Social Security and Medicare taxes. Additionally, sole proprietorships face a higher risk of IRS audits and offer fewer protections in terms of separating personal and business finances.
S-Corporation: The Tax Efficiency Play
Pros:
One of the most popular choices for solo entrepreneurs looking to minimize taxes is the S-Corporation. This structure allows you to split your income into a “reasonable salary” (subject to self-employment taxes) and distributions (not subject to those taxes). This strategy can lead to significant tax savings, especially as your business grows. S-Corps also allow business losses to pass through to your personal tax return, which can help offset other income.
Cons:
But there’s a tradeoff. The IRS can audit S-Corporation salaries to ensure they’re “reasonable,” and failing to meet this requirement can result in penalties. Filing taxes also becomes more complicated—you’ll need to file Form 1120S and issue K-1s to yourself as a shareholder. Plus, running payroll adds additional administrative and financial overhead. Lastly, limitations apply when using losses; you must have enough “basis” in the company to claim them.
C-Corporation: The Long Game
Pros:
C-Corporations are often considered ideal for businesses planning for substantial growth or eventual investment. One major perk is the flat 21% federal corporate tax rate (as of April 2025), which can be more favorable than personal income tax rates at higher income levels. C-Corps also have access to a broader range of deductions, credits, and strategic tax planning options. Most business-related expenses are fully deductible.
Cons:
However, the downside is the infamous “double taxation.” Your business pays corporate tax on its profits, and then you pay personal tax again on any dividends received. Corporate losses stay with the business and don’t pass through to your personal return. Filing and compliance are also more complex and costly.
Choosing the Right Identity
There’s no one-size-fits-all answer regarding how your business should be taxed. The best option depends on your income, goals, and how much complexity you’re willing to manage. Consulting with a qualified tax lawyer can help you find the balance between simplicity, tax efficiency, and long-term growth. Contact Colorado Trusts & Taxes for a free consultation.