Entity types

The choice that decides everything else

In the US, how your business is organized and how it is taxed are two separate decisions. Getting the distinction right is the difference between a correct return and an expensive one.

Entity is not the same as tax classification

An LLC is a creature of state law. It is not a tax classification, and the IRS has no LLC return. A single-member LLC is taxed as a sole proprietorship by default, but it can elect to be taxed as a C corporation on Form 8832, and then as an S corporation on Form 2553. A multi-member LLC defaults to partnership taxation and has the same elections available.

That means the same three letters — LLC — can sit on top of four completely different tax outcomes, with different forms, different due dates, different payroll rules and different self-employment tax exposure. Software that models only 'entity type' gets this wrong for a large share of its users.

Tax classification	Annual form	Owner on payroll?	Self-employment tax
Sole proprietor	Schedule C (Form 1040)	No — owner's draw only	Yes, on net profit via Schedule SE
Partnership	Form 1065 + K-1	No — guaranteed payments	Yes, for general partners
S corporation	Form 1120-S + K-1	Yes — and required if working	No on distributions; FICA on W-2 wages
C corporation	Form 1120	Yes	No — but profits are taxed twice
Tax-exempt	Form 990	Yes	No
Foreign-owned U.S. DE (FODE)	Pro forma Form 1120 + Form 5472	No — distributions only	No — the owner is not a US person
Foreign-owned U.S. DE, multi-member	Pro forma Form 1120 + Form 5472 + K-1	No — distributions only	No — the owner is not a US person

The foreign-owned LLC: no tax, and a $25,000 penalty

A US LLC owned by a person who is not a US person is a category of its own: a foreign-owned U.S. disregarded entity, a FODE. For income tax it does not exist — it is disregarded, and its result belongs to its owner, who as a nonresident is only taxed on US-source income. In the ordinary case that adds up to no federal income tax at all.

That is where the expensive misunderstanding starts, because since 2017 section 6038A and Regulations section 301.7701-2(c)(2)(vi) treat that same entity as a corporation for REPORTING purposes. It must obtain its own EIN and file a pro forma Form 1120 — page 1 alone, marked FOREIGN-OWNED U.S. DE — with a Form 5472 attached for each related party. Being exempt from tax is not being exempt from filing, and the penalty for missing the filing does not care that there was no profit.

With more than one foreign member the same package applies, and each member additionally gets a Schedule K-1 with their share of the result, issued ahead of the package so they can meet their own deadlines with it.

The zero that is almost never a zero

Part V of Form 5472 covers amounts paid or received in connection with the formation, dissolution, contributions to and distributions from the entity. So an LLC that never traded, never invoiced and never opened a bank account still has something to report if its owner paid the state formation fee out of their own pocket — that payment is a contribution to the entity, and it also feeds the gross-payments figure on lines 1f and 1h.

An ETBUS questionnaire that separates what actually creates a US trade or business — a US office, US employees, a dependent agent, services performed on US soil — from what does not, however often you have read otherwise: a US bank account, Stripe, US customers, a registered agent.
A related-party register with the identifiers Form 5472 requires, and one draft form per party rather than one per company.
Related-party ledger accounts that carry both their Form 1120 deduction line and their Form 5472 line, so the same rent paid to the owner lands on both without being entered twice.
The filing route spelled out: this package is not e-filed — it goes by fax or by mail to Ogden, Utah.

The S corporation trap

Reasonable compensation

S corporation distributions are not subject to FICA, so paying yourself a small salary and taking the rest as distributions saves employment tax. The IRS knows this. Officer compensation that is unreasonably low relative to profit is the single most commonly reclassified item in S corporation examinations, and the adjustment brings back employment taxes plus penalties and interest.

There is no statutory safe-harbor ratio. What defends the number is documentation: what comparable roles pay in your market, how many hours you work, and what the business would pay a non-owner to do the same job.

Kangaroo ERP flags a zero or unusually low officer compensation line whenever the entity is an S corporation with positive profit — at the point you run payroll, not nine months later.

Formation state versus operating state

Forming in Delaware, Nevada or Wyoming does not move your tax home. If you operate from California, you have California obligations regardless of where the entity was formed, plus the Delaware franchise tax and registered agent on top.

For a small operating business, forming in the state you actually work in is usually simpler and cheaper. The out-of-state formation story mostly makes sense for companies raising institutional capital.

Set it up correctly from the start

When you create your business, Kangaroo ERP asks for the entity and the tax election separately, shows you what each implies, and only offers combinations that legally exist.

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