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How Small Business Taxes Work

Common Basic Structures: LLCs and Corporations

The limited liability company, or LLC, is a more complicated structure to establish than a sole proprietorship or partnership, but not by much. Owners, called "members," typically just have to file one form to organize as an LLC, the "articles of organization" [source: Dahl].


An LLC is a legal entity. Its finances are separate from its owner's finances, and owners are not personally liable for debts incurred by or legal judgments made against their businesses. This is the main draw of the LLC: Owners of small businesses operating in fields with potentially substantial liability concerns, like construction or child care, are generally protected financially if something goes wrong [source: FindLaw].

Income Tax

While an LLC is a separate legal entity, it is not a separate tax entity. Income passes through an LLC just like it does for a sole proprietorship or partnership, taxed at the individual level and reported on owners' personal tax returns [source: SBA].

Employment/Self-employment Tax

LLC owners pay self-employment tax [source: SBA].

So LLCs solve the liability problem of sole proprietorships and partnerships, but they still face the hitch of the self-employment tax. To address that challenge, incorporation is required.


Corporations can have any number of owners, or "shareholders." The structure comes with a more complicated setup process and more paperwork in general, but it can be beneficial in terms of Medicare and Social Security taxes. (Income tax, not so much.)


Corporations are legal entities, so their owners typically are not personally liable for business debts [source: IRS].

Income Tax

Corporations are separate tax entities, so they pay income tax on their profit. Owners also pay income tax on that profit when it's distributed to shareholders. This effectively means the business's profits are taxed twice: once as business income and then again as personal income [source: SBA].

Employment/Self-employment Tax

Owners of a corporation can also be employees of the company, earning wages like any other employee. They can withhold employment taxes from their wages as they go, or they can pay self-employment taxes – but only on the profits they receive as wages. The rest of the profits are considered dividends and bonuses, which are not subject to employment or self-employment taxes [source: IRS].

The big hitch with the corporation is the double income tax. Enter the S corporation, available only to smaller businesses.