Business Entities

When people ask us “what kind of business should I be?” they’re usually asking two questions at once. One is legal: who is responsible if the business is sued or can’t pay its debts. The other is tax: which return gets filed, who pays the tax, and how much. The two get tangled together, so it helps to pull them apart.

The legal side is decided by what you form under state law: nothing at all, a partnership, an LLC, or a corporation. The tax side is decided by how the IRS classifies it, and for most small businesses that comes down to four choices: a sole proprietorship reported on Schedule C, a partnership on Form 1065, an S corporation on Form 1120-S, or a C corporation on Form 1120. The first three are “pass-through” businesses: the business itself pays no federal income tax, and the profit lands on the owners’ personal returns. The C corporation is the only one that pays its own tax.

The four side by side

This is the short version. The sections below explain each row.

Sole proprietorship Schedule C

If you go into business by yourself and don’t form anything, you’re a sole proprietor. There’s nothing to file with the state (other than a trade name if you use one), no separate return, and no separate bank account required by law, though you should absolutely have one. Your income and expenses go on Schedule C, and the profit is added to everything else on your Form 1040.

On top of income tax, you pay self-employment tax: 15.3% for Social Security and Medicare, because you’re both the employee and the employer. It’s figured on 92.35% of your profit, the Social Security part stops at $184,500 for 2026, and you deduct half of it in figuring your income tax. On $80,000 of profit, self-employment tax runs about $11,300 before you’ve paid a dime of income tax. That’s the number that makes people start asking about S corporations.

Most businesses should start here. A business that’s new, small, or still losing money gets nothing from a more complicated structure except more paperwork. The thing that makes or breaks a Schedule C is the bookkeeping. (See Lost at Sea: Self-Employed Without Books and Is It a Business or a Hobby?)

Partnership Form 1065

The moment two or more people go into business together to make a profit, they have a partnership for tax purposes, whether or not anyone signed anything. A handshake deal counts. Most partnerships today are set up as multi-member LLCs, which are taxed as partnerships unless they choose otherwise.

The partnership files Form 1065 by March 15 and gives each partner a Schedule K-1 showing their share of income, deductions, and credits. The partnership itself pays no federal tax. Partners pay on their share whether or not they took the money out, which surprises people the first year. Active partners also owe self-employment tax on their share and on any guaranteed payments, which work like a partner’s salary.

The partnership is the most flexible structure in the tax code, and that flexibility is the reason to choose one:

• Special allocations. Partners can divide income, losses, and deductions in proportions other than ownership, and change them when certain events happen, as long as the allocations reflect the real economics of the deal. A partner who put up the money can get the losses until he’s paid back; a partner who does the work can get a bigger share after that. No corporation can do this.
• Debt counts toward basis. Each partner’s share of the partnership’s debt increases their basis, which lets them deduct losses an S corporation shareholder couldn’t. That’s a big reason real estate is almost always held in partnerships.
• Property moves in and out more easily. Partners can contribute property tax-free at any time, with no “control” test like corporations have, and the partnership can generally distribute property back out without triggering tax.
• Basis can be adjusted. When a partner dies or sells out, the partnership can elect to step up its basis in its assets for the new owner. Corporations can’t.

The cost of that flexibility is complexity. A partnership needs a well-written partnership or operating agreement, the return takes more work, and the IRS charges a penalty for each partner, for each month a return is late. Partners in a general partnership are also personally liable for each other’s business debts, which is why LLCs have largely replaced them.

S corporation Form 1120-S

An S corporation isn’t a different kind of company under Colorado law. It’s a corporation or LLC that has filed Form 2553 asking to be taxed under Subchapter S. Like a partnership, it passes its income through to the owners on K-1s and files its return by March 15.

The reason most small businesses become S corporations is Social Security and Medicare tax. An owner who works in the business pays himself a reasonable salary through payroll, and payroll taxes apply to that salary. The rest of the profit comes out as a distribution, which isn’t subject to those taxes. On a business netting $150,000, that can be real money.

The rules are stricter than a partnership’s:

• A reasonable salary is required. Paying yourself $15,000 out of $150,000 of profit invites the IRS to reclassify distributions as wages, with back taxes and penalties.
• One class of stock. Income, losses, and distributions follow ownership percentages exactly, day by day. There are no special allocations.
• Limited owners. No more than 100 shareholders, and generally only U.S. citizens and residents, estates, and certain trusts. A partnership, a corporation, or a nonresident alien owning even one share ends the election.
• Losses need basis. You can deduct losses only up to what you’ve invested plus what you’ve personally loaned the company. Guaranteeing a bank loan doesn’t count until you actually pay on it.
• Getting property out is taxable. Distributing appreciated property, like a building, is treated as a sale. That’s why we don’t put real estate in an S corporation.

Then there’s the cost of running it: a separate corporate return, payroll and payroll returns, unemployment insurance, and Colorado FAMLI premiums. Figure $2,000 to $3,000 a year. Remember too that paying less into Social Security now means a smaller check later.

Some states tax the S corporation itself

The federal savings don’t always carry over to the state level. Colorado follows the federal treatment and doesn’t tax the S corporation itself, but some states do:

• California taxes S corporations at 1.5% of net income, with an $800 minimum each year.
• Illinois charges S corporations a 1.5% personal property replacement income tax.
• Texas applies its franchise (margin) tax to S corporations the same as any other business entity.
• Tennessee applies its franchise and excise taxes to S corporations.
• New York City and Washington, D.C. don’t recognize the S election and tax the company as a regular corporation.

If your business operates in other states, or you’re moving here from one of them, those taxes belong in the comparison.

C corporation Form 1120

A C corporation is the “regular” corporation. It’s a separate taxpayer: it files Form 1120 by April 15 and pays a flat 21% federal tax on its profit. That rate has been in place since 2018 and has no expiration date.

The catch is double taxation. When the corporation pays out its after-tax profit as dividends, the shareholders pay tax on it again. Here’s what $100,000 of profit looks like when it’s all paid out:

Owners who work in the business can reduce this by taking salary instead of dividends, since salary is deductible to the corporation and taxed only once. But it has to be reasonable for the work, and payroll taxes apply.

So why would anyone choose a C corporation? A few good reasons:

• Keeping money in the business. If profits are going back into growth rather than out to the owners, they’re taxed only at 21% for now, which may be lower than the owners’ personal rate. (Very large accumulations without a business reason can trigger an extra penalty tax.)
• Selling the company someday. Stock in a qualifying C corporation issued after July 4, 2025 and held at least five years can be sold with up to $15 million of gain excluded from federal tax, with a partial exclusion after three or four years. This is the qualified small business stock rule, and it has detailed requirements, but there’s nothing like it for other entities.
• Outside investors. Any number and any kind of shareholders, and multiple classes of stock. Venture investors generally expect a C corporation.
• Fringe benefits. Owner-employees can receive health insurance and certain other benefits tax-free, where S corporation owners must include them in wages.

The downsides: no 20% qualified business income deduction, losses stay trapped in the corporation instead of offsetting the owners’ other income, and getting appreciated property or accumulated earnings out, including at liquidation, is taxed twice. Converting a C corporation to an LLC or partnership later can be expensive for the same reason, so this is a choice to make with the end in mind.

Where does an LLC fit?

“LLC” is the most misunderstood word in small business tax. A limited liability company is a legal entity created under state law. It protects the owners’ personal assets from the company’s debts. It isn’t a tax classification at all. The IRS taxes an LLC as one of the four above:

• An LLC with one owner is ignored for income tax purposes and reported on Schedule C, unless it elects otherwise.
• An LLC with two or more owners is a partnership, unless it elects otherwise.
• Any LLC can elect to be taxed as an S corporation (Form 2553) or a C corporation (Form 8832). An election on Form 8832 generally can’t be changed again for five years.

That’s why the LLC is so popular: it gives you liability protection and lets you pick the tax treatment separately. Many businesses start as a single-member LLC filing Schedule C, then elect S corporation status once the income justifies it, without forming a new company.

Liability protection has limits, though. Banks often want a personal guarantee on business loans, and no entity protects you from your own negligence. For professionals in particular, that question belongs with an attorney.

Using more than one entity

Larger businesses often split things up. A common pattern is an operating company (often an S corporation) that runs the business, and a separate LLC taxed as a partnership that owns the building and leases it to the operating company. The building gets partnership treatment, the risks of the operating business stay away from the real estate, and the property can be passed on or sold without dragging the business along. It does mean more returns and more bookkeeping.

A few Colorado notes

• Colorado follows the federal choice. Colorado recognizes the S election and partnership treatment, so pass-through income is taxed on the owners’ Colorado returns. S corporations and partnerships file a Colorado return (Form DR 0106) as well as the federal one. Other states don’t all work this way, which matters if you do business across state lines.
• The pass-through entity election. Colorado lets partnerships and S corporations choose to pay the Colorado income tax at the business level. That can get the state tax around the federal cap on deducting state and local taxes. It’s worth a look for higher-income owners even with the higher cap under the 2025 tax law.
• Keep the LLC or corporation current. Colorado LLCs and corporations file a periodic report with the Secretary of State every year. Miss it and the company can go delinquent, which can put your liability protection at risk.
• Married couples. Colorado isn’t a community property state, so a business you and your spouse own together is a partnership for tax purposes by default. If it isn’t an LLC or other state-law entity, you may be able to elect to treat it as a “qualified joint venture” and each file a Schedule C instead. A Colorado LLC owned by both spouses files as a partnership.

Which one fits?

There’s rarely one right answer. It’s a balance of tax, liability, cost, and where you want the business to end up. But these rules of thumb cover most of the people who come through our door:

• Just starting, or netting under about $100,000Stay on Schedule C. Add a single-member LLC if you want liability protection; the taxes stay the same.
• Two or more ownersAn LLC taxed as a partnership, with a written operating agreement and a buy-sell agreement that says what happens if an owner dies, divorces, retires, or wants out.
• Real estate or other property that will grow in valueA partnership or LLC, never a corporation. Keep it separate from the operating business.
• One or a few working owners, consistently netting over about $100,000An S corporation election, with a reasonable salary and payroll set up properly from the start.
• Reinvesting most of the profit, raising outside money, or building to sellA C corporation, especially if the qualified small business stock exclusion could apply.

Whatever you choose, revisit it as the business changes. The structure that fits a first-year side business rarely fits that same business ten years later, and changing at the right time is much cheaper than changing in a hurry.

A business planning decision

Choosing an entity isn’t only a tax decision. It’s a business planning decision, and legal issues are often involved: liability protection, ownership and operating agreements, buy-sell provisions, and what happens when an owner leaves, dies, or sells. Getting those right at the start costs far less than fixing them later. We refer our tax clients to Tyler Murray at Murray & McCarthy Law in Denver for the legal side, and we work alongside him on the tax side: the elections, payroll setup, and the returns that follow.