Choosing an Entity: Sole Prop, S-Corp, or C-Corp

How it works

Entity choice is the single lever that decides how a business's profit gets taxed at the federal level, and for a small operating business there are three live regimes to choose among: staying a sole proprietorship or a single-member LLC, electing S-corp status, or operating as a C corporation. What changes across the three is not the business itself but which slice of the same profit is exposed to which tax.

A sole proprietorship, or a single-member LLC that stays disregarded for federal tax purposes under the check-the-box regulations, is the default and the simplest of the three. All of the profit flows onto the owner's Schedule C, and the full amount of net earnings is subject to self-employment tax: a combined 15.3 percent, computed on 92.35 percent of net earnings, up to an annually adjusted Social Security wage base, then Medicare only at 2.9 percent above it. There is no payroll to run and no separate business return to file. Section 1401 sets that rate and Section 1402 defines what counts as net earnings from self-employment.

Electing S-corp status changes which dollars are exposed to that tax, not whether the tax exists. The owner becomes an employee of the corporation, is paid a wage the IRS calls reasonable compensation, and only that wage is subject to FICA. The profit left over after the wage passes through on a Schedule K-1 as a distribution. That distribution is not self-employment income, a position the IRS confirmed in Revenue Ruling 59-221, and it is not FICA wages either, since FICA only ever reaches an actual wage payment. That is the entire mechanism behind an S-corp election: it does not lower the rate on anything, it moves part of the profit from a category that bears FICA into a category that does not. Sections 1361 and 1362 govern eligibility and the mechanics of making the election, and I walk through the filing itself, the deadline, and the reasonable-comp math in my Florida S-corp guide.

A C corporation is taxed on its own return at a flat 21 percent rate under Section 11(b), with no graduated brackets, and then taxed again when profit is distributed as a dividend. For a business that pays out what it earns every year, that second layer generally makes a C corporation the most expensive of the three structures. It earns its place for a different reason: it is the only structure whose stock can qualify for the Section 1202 qualified small business stock exclusion, a large exclusion of gain when the stock is later sold, at the cost of carrying the entity-level tax and the double tax on distributions in the meantime. I cover the mechanics, and the traps, in C-corp uses and traps.

What this is worth in Florida

Florida changes less about this decision than people expect, and I would rather say that plainly than let it be oversold. Florida has no individual income tax and does not tax pass-through income at the owner level, so the sole-prop-versus-S-corp choice is a federal question only. Where Florida does show up is on the C-corp side of the tree: Florida imposes its own 5.5 percent corporate income tax on a C corporation's income, a third layer on top of the federal rate and the tax on any dividend, one a pass-through never faces. It also charges reemployment tax on W-2 wages, so an S-corp election adds a small state payroll cost the sole-prop version never had. Every entity still has to stay current with the state through Sunbiz, a separate question I cover in my Florida LLC annual report guide.

Who this applies to

Every operating business starts somewhere on this tree, and where it starts is usually obvious. A new or lower-profit business, or one with irregular income, fits the sole-proprietorship or single-member-LLC bucket by default, and often should stay there. Since a disregarded LLC is taxed exactly like a sole proprietorship, that choice does not depend on whether the owner has wrapped the business in one; the mechanics of that layer are their own subject, in my LLC basics piece.

An S-corp election is available only to a corporation, or an LLC electing to be treated as one, that meets Section 1361(b)'s definition of a small business corporation: no more than 100 shareholders, with family members permitted to be treated as one; only eligible shareholders, meaning individuals, estates, certain trusts, and organizations exempt under Section 401(a) or 501(c)(3), never a nonresident alien, a partnership, or a C corporation; one class of stock, though differing voting rights are allowed and qualifying straight debt is not a second class; and not one of the statute's ineligible corporation types, such as certain financial institutions, an insurance company taxed under subchapter L, or a domestic international sales corporation. Meeting that list is necessary but not sufficient; there also has to be enough profit above a defensible salary for the FICA savings to clear the added cost, addressed next.

A C corporation is open to anyone; nothing has to be met to simply be one. Getting real value out of the structure, specifically out of Section 1202, is narrower and requires all of the following at once:

• A domestic C corporation only. An S corporation cannot issue qualified small business stock.
• Aggregate gross assets of $75,000,000 or less, tested through issuance and immediately after, for stock issued after July 4, 2025. Older stock keeps the prior $50,000,000 ceiling.
• An active qualified trade or business, meaning at least 80 percent of assets are used in the active conduct of the business, and the business is not one of the specified service fields the statute excludes, among them health, law, accounting, consulting, financial services, and brokerage. My own practice sits in one of those excluded fields, so its equity could never qualify for this exclusion.
• Stock acquired at original issuance, for money, property other than stock, or services, rather than purchased later from another shareholder.

The Section 199A deduction sits alongside all of this rather than inside any one branch, and belongs on the eligibility side of the decision as much as the FICA math does. It is available to a sole proprietorship, a partnership, and an S corporation, never to a C corporation, and for a specified service trade or business, such as a CPA practice or a law firm, it phases out over a range above a threshold Section 199A(e) indexes every year, not at the threshold itself. For 2026 that threshold is $201,750 for a single filer and $403,500 for a joint return, and the phase-in range runs to $276,750 and $553,500 respectively, under Revenue Procedure 2025-32. Below the threshold, even a specified service business gets the full deduction; inside the range it gets a partial one; only above the range does it reach zero.

What it requires

The three regimes line up against net income in a rough, not rigid, order:

Below the first line, the FICA savings cannot clear the cost of payroll and a corporate return; above the third, a defensible salary leaves enough distribution for those savings to clear it. In between, the answer turns on the specific reasonable-comp number, not the profit figure alone.

Making the S election carries a fixed deadline under Section 1362(b): Form 2553 has to be filed within two months and fifteen days of the start of the tax year the election is to cover, March 15 for a calendar-year business, or at any point during the preceding year. Missing that date is not automatically fatal; a reasonable-cause procedure can restore the election, and I cover its mechanics, including how far back it can reach, in my late-election relief piece. Once in effect, the corporation files Form 1120-S annually and the owner-employee needs real payroll, not an informal draw.

The salary itself carries a substantive requirement, not just a filing one. Section 3121 defines what counts as wages for FICA purposes, and the wage paid has to be reasonable for the services actually performed before any distribution is taken. That single requirement drives more audit risk than everything else on this page combined.

What you need to document

Reasonable-compensation support

Comparable-role pay data, from a survey service or published wage statistics, plus a record of the owner's actual hours, duties, and experience. A short memo connecting the salary to that evidence is worth more at examination than the number alone.

A clean cap table and distribution record

Shareholder agreements and distributions that stay pro rata and match the eligible-shareholder rules. A side arrangement or a disproportionate distribution is what actually creates a second class of stock or an ineligible shareholder.

Payroll and filing records once S status is in effect

Actual W-2s, withholding deposits, and quarterly payroll filings, plus the annual Form 1120-S. A distribution paid before any payroll exists is what invites recharacterization.

A contemporaneous QSBS file, for the C-corp branch

Basis and issuance date, tracked from the day the stock is issued, along with the corporation's gross-assets figure at issuance and immediately after. Neither is reconstructible with any confidence once the stock is finally sold.

Where it goes wrong

What Watson and Spicer Accounting establish

The dominant failure mode on this entire tree is an S-corp salary set too low. Watson v. United States, 668 F.3d 1008 (8th Cir. 2012), and Spicer Accounting v. United States, 918 F.2d 90 (9th Cir. 1990), are the two cases behind that: both upheld the IRS recharacterizing distributions as wages because the salary actually paid did not reflect a reasonable amount for the services the shareholder-employee performed. Revenue Ruling 74-44 said the same thing decades earlier: a payment structured as a distribution in place of compensation is wages, regardless of the label the corporation puts on it. Once that recharacterization happens, the corporation owes the FICA it should have withheld, plus penalties and interest, on money it already told everyone was a distribution.

The recurring mistakes

• An election that terminates without anyone deciding to end it. A disproportionate distribution, a side agreement among shareholders, or an ineligible shareholder acquiring stock can each violate Section 1361(b), and any of them ends the election under Section 1362(d)(2) without a filing or a notice. A missed deadline is fixable through late-election relief; a genuine eligibility defect is not, because there is nothing to grant relief from.
• Electing S status before there is enough profit to justify it. Below the point where the FICA savings clear the cost of payroll and a corporate return, the election buys complexity without buying anything back for it.
• Defaulting into a C corporation for a cash-distributing service business. Without reinvestment and without Section 1202 in view, a C corporation adds the 21 percent federal rate, Florida's 5.5 percent corporate tax, and a second tax on any dividend, with no Section 199A deduction to offset any of it, almost always the wrong default for a profitable Florida service business. A business that drifted into it is not stuck; converting out has its own timing rules, covered in C-corp to S-corp late election.
• Claiming Section 1202 on the wrong facts. A specified service business, a corporation whose assets crossed the ceiling, stock sold before its holding period, or stock issued before July 4, 2025 evaluated under the newer tiers, are all fact patterns where the exclusion is simply not available.
• Getting the Section 199A math backward. Assuming the full deduction survives for a specified service business above the threshold, when it is phasing down across the range above it, or writing it off entirely at the threshold when a partial deduction is still there, or forgetting that a higher S-corp salary shrinks the K-1 income the deduction is measured against.

A situation where this comes up

The version I see most often is a Florida service business that has been profitable and stable on Schedule C well past the point where the FICA math favors a change, and the owner has simply never gotten around to it. Nothing about the business itself has to change for an S-corp election to become available. What has to happen is the less exciting part: setting up payroll, running an actual reasonable-comp analysis instead of picking a round number, and filing Form 2553 before the deadline.

The C-corp branch shows up differently, and far less often: the founder of an operating or product business, reinvesting nearly everything back into the company, thinking about a future sale rather than annual distributions. For that fact pattern, and mainly for it, the flat 21 percent rate and a possible Section 1202 exclusion at sale can outweigh giving up pass-through treatment in the meantime. It is a decision made with a specific exit in mind, not a default.

The situation that concerns me is a business that elects S status the same year it crosses into profitability, before there is enough gap between a defensible salary and the profit left over, because someone heard the strategy works and skipped modeling it first. The election is easy to make and not always easy to unwind. Running the numbers before filing costs nothing; filing first and finding out they do not work costs a year of compliance for no benefit.