Business Entity Types Explained: LLC, S-Corp, C-Corp, and Sole Proprietor
You started freelancing. Clients are paying you. You’re making real money.
Now what? Do you need an LLC? Should you be an S-Corp? Or can you just stay a sole proprietor?
Most new entrepreneurs overthink this decision—or ignore it entirely and get surprised by taxes or liability issues later.
The truth: Your business structure affects:
- How much you pay in taxes (difference can be $3,000-$10,000+/year)
- Your personal liability (can creditors come after your house?)
- How much paperwork you deal with
- Your ability to raise funding (if relevant)
This guide breaks down the 4 main business structures:
- Sole proprietor (simplest, riskiest)
- LLC (best for most dropouts)
- S-Corp (tax optimization at scale)
- C-Corp (if seeking venture funding)
By the end, you’ll know exactly which structure is right for your situation and how to set it up.
The 4 Business Structures Compared
| Feature | Sole Proprietor | LLC | S-Corp | C-Corp |
|---|---|---|---|---|
| Formation cost | $0 | $50-$500 | $100-$800 | $500-$2,000 |
| Ongoing cost/year | $0 | $50-$800 | $800-$2,000 | $2,000-$5,000+ |
| Liability protection | ❌ None | ✅ Yes | ✅ Yes | ✅ Yes |
| Taxes | Personal income | Pass-through | Pass-through + payroll | Double taxation |
| Self-employment tax | 15.3% on all profit | 15.3% on all profit | Only on salary | N/A |
| Paperwork | Minimal | Low | Moderate | Heavy |
| Best for | Testing an idea | Most small businesses | $60K+ profit | Venture-backed startups |
Quick recommendation:
- Making under $10K/year: Sole proprietor
- Making $10K-$60K/year: LLC
- Making $60K+ profit/year: S-Corp (or LLC taxed as S-Corp)
- Raising venture capital: C-Corp
Let’s break down each option.
Option 1: Sole Proprietor (Default, Simplest, Riskiest)
What it is: You ARE the business. No legal separation between you and your business.
How it works:
- You start working, collecting money from clients
- You’re automatically a sole proprietor (no paperwork required)
- You report income on Schedule C of your personal tax return
- You pay self-employment tax (15.3%) on all profits
Example:
- You freelance as a web developer
- You made $40,000 this year
- Your expenses: $10,000
- Net profit: $30,000
- Self-employment tax: $4,590 (15.3% of $30,000)
- Income tax: ~$3,300 (12% bracket, after deductions)
- Total taxes: $7,890 (26.3%)
Pros of Sole Proprietor
✅ Free - No formation costs ✅ Simple - No separate tax return (just Schedule C) ✅ Easy to start - You’re already one if you’re freelancing ✅ Minimal paperwork - No annual reports or filings
Cons of Sole Proprietor
❌ No liability protection - If you get sued or can’t pay business debts, they can take your house, car, personal savings ❌ Higher self-employment tax - 15.3% on ALL profits (no way to reduce this) ❌ Less credible - “John Smith” vs “Smith Consulting LLC” ❌ Harder to sell - Can’t sell a sole proprietorship
Who Should Be a Sole Proprietor
You if:
- You’re just testing an idea (making under $10K/year)
- You have almost zero liability risk (no clients, no inventory, no employees)
- You want to keep things dead simple
Not you if:
- You’re making $10K+ per year
- You have any meaningful liability risk
- You want to appear professional
Bottom line: Sole proprietor is fine when you’re just starting out, but upgrade to LLC once you’re making real money.
Option 2: LLC (Best for Most College Dropouts)
What it is: A legal entity that separates your personal assets from your business assets.
How it works:
- You file paperwork with your state ($50-$500)
- Your business is now a separate legal “person”
- You report income on your personal tax return (pass-through taxation)
- You pay self-employment tax (15.3%) on all profits
- Your personal assets are protected from business liability
Example (same numbers as sole proprietor):
- You run a web development LLC
- You made $40,000 this year
- Your expenses: $10,000
- Net profit: $30,000
- Self-employment tax: $4,590 (15.3% of $30,000)
- Income tax: ~$3,300
- Total taxes: $7,890 (same as sole proprietor)
Wait, same taxes? So why bother with an LLC?
Answer: Liability protection.
The Liability Protection Advantage
Scenario 1: You’re a sole proprietor
- A client sues you for $100,000
- You lose (or settle for $75,000)
- You don’t have business insurance
- Result: They can take your house, car, savings to pay the judgment
Scenario 2: You’re an LLC
- A client sues your LLC for $100,000
- You lose (or settle for $75,000)
- Result: They can only take LLC assets (business bank account, equipment). Your house, car, and personal savings are protected (as long as you’ve followed proper LLC formalities).
This protection is worth $50-$500/year in formation + annual fees.
Pros of LLC
✅ Liability protection - Personal assets separated from business ✅ Simple taxes - Still pass-through (report on personal return) ✅ Professional image - “Smith Consulting LLC” > “John Smith” ✅ Flexible ownership - Can add partners easily ✅ Low cost - $50-$500 to form, $50-$800/year to maintain
Cons of LLC
❌ Costs money - Formation + annual fees ❌ Annual paperwork - Depending on state (usually minimal) ❌ Self-employment tax still applies - 15.3% on all profits (can’t optimize this in a regular LLC)
Who Should Form an LLC
You if:
- You’re making $10K+/year
- You have any client-facing work (liability risk)
- You want to appear more professional
- You have partners or might add partners later
Most college dropout entrepreneurs should form an LLC when they hit $10K-$15K/year in revenue.
Option 3: S-Corp (Tax Optimization for Higher Earners)
What it is: An IRS tax election that lets you split your income into salary + distributions.
How it works:
- You still form an LLC (S-Corp is a tax election, not a separate entity)
- You elect S-Corp status with the IRS
- You pay yourself a “reasonable salary” (subject to payroll taxes)
- Remaining profit is distributed as “dividends” (NO self-employment tax)
Example:
- You run a web development LLC making $80,000 profit
- You elect S-Corp status
- You pay yourself $50,000 salary (reasonable for your work)
- Remaining $30,000 = distribution
Tax calculation:
- Salary: $50,000
- Self-employment tax: $7,650 (15.3%)
- Income tax: ~$6,000
- Distribution: $30,000
- Self-employment tax: $0 (key savings!)
- Income tax: ~$3,600
- Total taxes: $17,250
Compare to LLC (not S-Corp):
- Profit: $80,000
- Self-employment tax: $12,240 (15.3%)
- Income tax: ~$9,600
- Total taxes: $21,840
S-Corp savings: $4,590/year
Pros of S-Corp
✅ Significant tax savings - Save 15.3% on distributions ($3,000-$10,000+/year) ✅ Liability protection - Same as LLC ✅ Professional image - Same as LLC
Cons of S-Corp
❌ Higher costs - $800-$2,000/year in payroll services + accounting ❌ More paperwork - Quarterly payroll filings, annual returns ❌ Must pay “reasonable salary” - Can’t just take all profits as distributions (IRS audits this) ❌ Ongoing complexity - Need accountant and payroll service
Who Should Be an S-Corp
You if:
- You’re making $60K+ in profit (not just revenue)
- You have predictable income
- You’re willing to deal with payroll complexity
- You have an accountant (or budget for one)
Break-even calculation:
- S-Corp saves you ~15.3% on distributions
- S-Corp costs ~$1,500-$2,500/year more than LLC
- Break-even: ~$20K-$30K in distributions
Rule of thumb: If your profit exceeds $60K, S-Corp usually saves money.
How “Reasonable Salary” Works
The IRS rule: You must pay yourself a salary that’s “reasonable” for the work you do.
What’s reasonable?
- Check salary data for your role/location (Glassdoor, PayScale)
- Typically 40-60% of total profit
- If you made $100K profit, paying yourself $10K salary = audit risk (obviously too low)
Example guidance:
| Total Profit | Reasonable Salary | Distribution |
|---|---|---|
| $60,000 | $40,000 | $20,000 |
| $80,000 | $50,000 | $30,000 |
| $100,000 | $60,000 | $40,000 |
| $150,000 | $80,000 | $70,000 |
IRS can reclassify your distributions as salary (and charge penalties) if you’re too aggressive.
Option 4: C-Corp (For Venture-Backed Startups Only)
What it is: A separate legal entity that pays its own taxes (before distributing profits to shareholders).
How it works:
- You form a corporation
- The corporation pays corporate income tax (21% federal)
- When you take money out (as dividends), you pay personal income tax
- Double taxation (corporation pays tax, then you pay tax on what you receive)
Example:
- Your C-Corp makes $100,000 profit
- Corporate tax (21%): $21,000
- After-tax profit: $79,000
- You take $79,000 as dividends
- Personal tax on dividends (15-20%): ~$12,000
- Total taxes: $33,000 (33%)
Compare to LLC (pass-through):
- $100,000 profit
- Self-employment tax: $15,300
- Income tax: $12,000
- Total taxes: $27,300 (27.3%)
C-Corp costs you MORE in taxes. Why would anyone choose this?
When C-Corps Make Sense
1. Raising venture capital
- VCs strongly prefer C-Corps (easier to issue stock, multiple share classes)
- Converting from LLC to C-Corp later is complicated
2. Keeping profits in the business
- If you’re reinvesting 100% of profits (not taking distributions), corporate tax rate (21%) is lower than personal rates (22-37%)
3. Going public someday
- IPOs require C-Corp structure
For 99% of college dropout entrepreneurs: You don’t need a C-Corp.
Pros of C-Corp
✅ Easier to raise VC funding - Standard structure for investors ✅ Can issue multiple share classes - Preferred stock, common stock ✅ Lower corporate tax rate - 21% (if reinvesting profits)
Cons of C-Corp
❌ Double taxation - Pay tax twice on the same profit ❌ Expensive to maintain - $2,000-$5,000+/year in accounting/legal ❌ Complex - Board meetings, bylaws, stock ledgers ❌ More regulations - Securities laws, investor reporting
Bottom line: Only form a C-Corp if you’re raising venture capital or planning an IPO.
State-by-State Formation Costs
LLC formation costs (one-time):
| State | LLC Filing Fee | Annual Fee/Tax |
|---|---|---|
| Wyoming | $100 | $60/year |
| Delaware | $90 | $300/year |
| Nevada | $75 | $350/year |
| Florida | $125 | $138.75/year |
| Texas | $300 | $0 (but franchise tax if revenue > $1.23M) |
| California | $70 | $800/year (painful) |
| New York | $200 | $9/year (plus publication req ~$1,000) |
| Average | $100-$200 | $50-$300/year |
Pro tip: Form in your home state unless you have a specific reason not to (like significant California franchise tax).
How to Form an LLC (Step-by-Step)
Step 1: Choose a Business Name
Requirements:
- Must be unique in your state
- Must include “LLC” or “Limited Liability Company”
- Can’t use restricted words (Bank, Insurance, etc.)
Check availability:
- Search your state’s Secretary of State website
- Reserve the name if needed ($10-$50)
Step 2: Choose a Registered Agent
What it is: A person/company that receives legal documents on behalf of your LLC.
Options:
- Yourself (free, but your address becomes public record)
- Registered agent service ($50-$300/year, keeps your address private)
Recommended services:
- Northwest Registered Agent ($125/year)
- Incfile (free with formation package)
- LegalZoom ($299+/year)
Step 3: File Articles of Organization
Where: Your state’s Secretary of State website
Cost: $50-$500 (varies by state)
Info needed:
- LLC name
- Registered agent name and address
- Member names (your name)
- Purpose of business (usually “any lawful purpose”)
Processing time: 1-6 weeks (pay extra for expedited processing in most states)
Step 4: Create an Operating Agreement
What it is: Internal document outlining how your LLC operates.
What it includes:
- Ownership percentages
- Member responsibilities
- Profit distribution rules
- Decision-making process
Do you legally need one? Depends on state (some require, some don’t).
Should you have one anyway? Yes (especially if you have partners).
How to create:
- Use a template (search “LLC operating agreement template [your state]”)
- Have a lawyer review ($200-$500)
Step 5: Get an EIN (Free)
What it is: Employer Identification Number (like a social security number for your business)
Why you need it:
- Open business bank account
- Hire employees
- File taxes
- Apply for business credit
How to get it:
- Go to IRS.gov
- Apply online (takes 10 minutes)
- Cost: $0
Step 6: Open a Business Bank Account
Why: Keep business finances separate from personal (critical for liability protection).
What you’ll need:
- Articles of Organization
- EIN letter
- Operating Agreement
- Your ID
Recommended banks:
- Chase Business Checking - $0/month with $2K balance
- Bank of America Business Advantage - $16/month (waived with $5K balance)
- Mercury - $0/month (online bank, great for startups)
- Novo - $0/month (online bank, no fees)
Step 7: File Annual Reports (Ongoing)
What: Most states require annual or biennial reports.
Cost: $50-$300/year
Deadline: Varies by state (often on formation anniversary)
Penalty for missing: Late fees, eventual dissolution of LLC
Set a calendar reminder!
When to Switch Entities
Sole Proprietor → LLC
When: Hit $10K-$15K/year in revenue OR you have meaningful liability risk
Process: File LLC formation documents (see steps above)
Cost: $100-$500 one-time + $50-$300/year
LLC → S-Corp
When: Profit exceeds $60K/year AND you have consistent income
Process:
- File Form 2553 with IRS (by March 15 or within 75 days of forming LLC)
- Set up payroll system
- Start paying yourself salary + distributions
Cost: $0 to IRS (but $1,500-$2,500/year in payroll + accounting)
LLC → C-Corp
When: Raising venture capital or planning IPO
Process:
- File articles of incorporation
- Issue stock
- Transfer LLC assets to corp
- (Complex - hire a lawyer)
Cost: $1,000-$5,000 in legal fees
Tax Implications Summary
| Entity | Self-Employment Tax | Income Tax | Total Tax (Example: $80K profit) |
|---|---|---|---|
| Sole Proprietor | 15.3% on all profit | 12-22% | ~$21,840 (27.3%) |
| LLC | 15.3% on all profit | 12-22% | ~$21,840 (27.3%) |
| S-Corp | 15.3% on salary only | 12-22% | ~$17,250 (21.6%) |
| C-Corp | N/A | 21% corporate + 15-20% personal | ~$33,000 (33%) |
Key insight: LLC and sole proprietor have same tax treatment (pass-through). S-Corp saves ~5-6% at higher incomes.
Common Mistakes to Avoid
Mistake 1: Forming a C-Corp Too Early
Why it’s bad: You’ll pay double taxation unnecessarily.
Fix: Start with LLC. Convert to C-Corp only when raising VC.
Mistake 2: Electing S-Corp Too Early
Why it’s bad: Added complexity + costs when profit doesn’t justify it.
Fix: Wait until you’re making $60K+ profit.
Mistake 3: Mixing Personal and Business Finances
Why it’s bad: “Pierces the corporate veil” (eliminates liability protection).
Fix: Always use business bank account for business expenses. Never use personal account for business.
Mistake 4: Not Paying Yourself a Reasonable Salary (S-Corp)
Why it’s bad: IRS can reclassify distributions as salary + penalties.
Fix: Pay yourself 40-60% of profit as salary (check industry standards).
Mistake 5: Not Filing Annual Reports
Why it’s bad: State dissolves your LLC (lose liability protection, pay reinstatement fees).
Fix: Set calendar reminder for annual report deadline.
Your Entity Selection Action Plan
This Week:
- Calculate your annual profit (revenue - expenses)
- Assess liability risk (client-facing? physical products?)
- Choose entity type using decision tree above
- Decide: Form now or wait?
If Forming LLC:
- Choose business name (check availability)
- Choose registered agent
- File Articles of Organization
- Get EIN (IRS.gov)
- Open business bank account
- Create operating agreement
- Set calendar reminder for annual report
If Electing S-Corp:
- Confirm profit > $60K
- Hire accountant (get referrals)
- File Form 2553 with IRS
- Set up payroll service (Gusto, QuickBooks Payroll)
- Determine reasonable salary
- Start paying yourself biweekly
Ongoing (Every Year):
- File annual report (state)
- Review entity choice (should you switch?)
- Update operating agreement (if members/ownership changed)
- Maintain separate business finances
Related Articles
Building your business? Check out these guides:
- Start & Scale Your Business as a College Dropout - Complete founder’s guide
- Taxes for the Self-Taught: College Dropout Guide to Freelance Taxes - Understand your tax obligations
- Pricing Your Service or Product - Earn what you’re worth
- Lean Startup Guide for College Dropouts - Validate before you build
The Bottom Line
Choose your business entity based on profit and complexity:
Under $10K/year: Sole proprietor (free, simple)
$10K-$60K/year: LLC ($100-$500 to form, $50-$300/year)
- Liability protection
- Professional image
- Simple taxes
$60K+ profit/year: S-Corp ($1,500-$2,500/year)
- Save $3,000-$10,000/year in taxes
- Added complexity (payroll, accounting)
- Must pay reasonable salary
Raising VC funding: C-Corp ($2,000-$5,000+/year)
- Preferred by investors
- Double taxation
- Maximum complexity
For 90% of college dropout entrepreneurs: Start with LLC. Switch to S-Corp when profit exceeds $60K.
How to form an LLC:
- Choose name
- File with state ($100-$500)
- Get EIN (free, IRS.gov)
- Open business bank account
- Done
Don’t overthink it. Start with LLC, focus on growing revenue, optimize entity structure later.
Your business structure matters—but your product and customers matter more.
Get the structure right, then get back to work.
