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 |
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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