Starting a business is exciting, but choosing the right legal structure can have major tax and liability consequences. Whether you are launching a side hustle or building something scalable, understanding how each entity works from a legal and tax perspective is critical. Here is a practical breakdown of the most common business structures and the key corporate tax concepts that go with them.
Sole Proprietorship
A sole proprietorship is the most common business structure. It is owned by one individual, or in some cases two spouses in a community property state.
It is very easy to form and manage. There are no formal organizational documents required at the state level, although you may need to file an assumed name certificate if operating under a DBA, which stands for doing business as. Simply using words that describe your services does not count as an assumed name.
The downside is unlimited liability. The owner is personally responsible for all business debts. The business also has a limited life because it does not legally exist apart from the owner.
From a tax standpoint, there is no separate business tax return. The owner reports income and expenses on Schedule C of their Form 1040. Profits flow directly to the owner and are taxed as ordinary income. The owner also pays self employment tax. In Texas, sole proprietorships are not subject to the Texas franchise tax.
General Partnership
A general partnership is an unincorporated business with two or more owners. It is relatively easy to form and manage and can even be created through a verbal agreement.
Partners may be individuals or other business entities. However, at least two general partners are required, and each partner has unlimited liability. Partners can bind the partnership legally and are jointly and severally liable for its debts.
For tax purposes, the partnership files Form 1065, but it does not pay income tax. Instead, each partner receives a Schedule K 1 reporting their share of income or loss, which they include on their own return. General partners pay self employment tax. Distributions of profit are generally tax free because the income has already been taxed to the partner. In Texas, general partnerships are not subject to franchise tax.
Limited Liability Partnership and Limited Partnership
A Limited Liability Partnership or LLP is similar to a general partnership but requires registration with the state. The major advantage is limited liability protection for partners. In Texas, LLPs are subject to franchise tax.
A Limited Partnership or LP must have at least one general partner and one limited partner. General partners manage the business and have unlimited liability. Limited partners are typically passive investors. They have limited liability but cannot participate in management.
For tax purposes, partnerships still file Form 1065. General partners pay self employment tax, but limited partners generally do not. Limited partnerships and LLPs in Texas are subject to franchise tax.
Corporation
A corporation is a separate legal entity. One person can simultaneously be a shareholder, board member, and officer.
Corporations offer limited liability for shareholders and unlimited life. They are easier to use when attracting investors. Shareholders can be individuals or other entities, and there is no limit on the number of owners.
The tradeoff is complexity and potential double taxation. A C corporation files Form 1120 and pays its own corporate income tax. When profits are distributed as dividends, shareholders pay tax again. Shareholders do not pay self employment tax, and they can also be employees of the corporation. Corporations in Texas are subject to franchise tax.
Forming a corporation involves filing articles of incorporation with the Secretary of State. Shareholders elect a board of directors. The board hires officers, and officers run daily operations. Shareholders vote on major issues such as electing the board, approving mergers, or dissolving the company. The board focuses on strategy and protecting shareholder interests.
S Corporation
An S corporation is legally a corporation but taxed more like a partnership. It files Form 1120S, and income flows through to shareholders via Schedule K 1. The S corporation does not pay federal income tax.
This structure avoids double taxation. Distributions are generally tax free to the extent of basis. Shareholders who work for the business must receive reasonable compensation as wages, which are subject to FICA tax. Remaining profits are not subject to self employment tax.
To qualify, the corporation must meet specific requirements. It must be incorporated in the United States, have only one class of stock, have no more than 100 shareholders, and shareholders must generally be individuals or certain estates. Nonresident aliens cannot be shareholders. The election is made by filing Form 2553 with the IRS.
Limited Liability Company
A Limited Liability Company or LLC combines features of corporations and partnerships. It offers limited liability to members and flexibility in management. It is generally easier to form than a corporation but still requires filing organizational documents with the state.
For tax purposes, an LLC with one member is treated by default as a sole proprietorship. An LLC with two or more members is treated by default as a partnership. However, an LLC can elect to be taxed as a C corporation or S corporation. In Texas, LLCs are subject to franchise tax. LLCs cannot be publicly traded like corporations.
Corporate Capital: Debt vs Equity
When funding a corporation, owners can contribute equity or loan money as debt.
Equity contributions are generally not taxable to the corporation. There is no obligation to repay the funds. However, dividends are not deductible, which contributes to double taxation.
Debt financing requires repayment, but interest payments are deductible to the corporation. Principal repayments are not taxable to the lender. Interest income is taxable to the lender, often at higher ordinary rates. Lenders typically have no control over corporate operations.
The IRS may reclassify debt as equity if the company is excessively leveraged, does not follow formal loan terms, charges no or minimal interest, or lacks a written agreement.
Section 351 Transfers to Corporations
Under Section 351 of the Internal Revenue Code, no gain or loss is recognized when property is transferred to a corporation in exchange for stock, provided the transferors control at least 80 percent of the corporation immediately after the exchange. Services do not qualify as property.
If the corporation gives stock plus cash or other property, known as boot, the shareholder recognizes gain but not loss. The taxable gain is the lesser of the realized gain or the value of the boot received.
Section 358 determines the shareholder’s basis in the stock received. Section 362 determines the corporation’s basis in the property received. Importantly, the corporation does not recognize gain when issuing stock for property.
Earnings and Profits and Distributions
Earnings and profits, often called E and P, measure a corporation’s ability to pay dividends. It is similar to retained earnings but calculated under tax rules.
When a corporation makes a non liquidating distribution to shareholders, it is treated in layers. First, it is a dividend to the extent of current and accumulated E and P. Dividends are taxable to shareholders. If the distribution exceeds E and P, it is a nontaxable return of capital up to the shareholder’s basis in stock. Any remaining amount is capital gain.
Understanding E and P is critical because it determines whether distributions are taxed as dividends or capital gains.
Partnership Tax Concepts
Partnerships are formed by two or more persons carrying on a trade or business. They can include individuals, corporations, trusts, estates, or even other partnerships.
Partnerships file Form 1065 but do not pay income tax. Income flows through to partners via Schedule K 1. General partners pay self employment tax, while limited partners typically do not. Distributions are generally not taxable unless they exceed the partner’s outside basis.
Section 721 provides nonrecognition treatment similar to Section 351 for corporations. When a partner contributes property to a partnership in exchange for an interest, no gain or loss is generally recognized.
The partnership’s basis in its assets is called inside basis. The partner’s basis in their partnership interest is called outside basis. Outside basis cannot go below zero. Distributions in excess of basis are treated as capital gains.
Final Thoughts
Each business structure has tradeoffs between liability protection, administrative complexity, and tax treatment. Sole proprietorships and partnerships offer simplicity but expose owners to personal liability. Corporations provide strong liability protection and easier access to capital but may create double taxation. S corporations and LLCs offer flexibility and flow through taxation but come with eligibility rules and compliance requirements.
Choosing the right structure is not just a legal decision. It is a tax strategy that affects how profits are taxed, how losses are used, and how investors are brought into the business. Understanding these foundational concepts helps business owners make informed decisions that align with their long term goals.
Beyond The Tradeoff 
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