Part II · Planning — How the Code Rewards Behavior · pp. 131–150

Chapter 9: Entity Selection and Restructuring

Entity selection is the most consequential tax decision a business owner makes, and it must be deliberate, documented, and revisited as circumstances and tax law change.

Overview

This chapter treats the choice of business entity as primarily a tax decision rather than a legal one. The legal form a business operates through determines how income is characterized, how tax is calculated, what planning strategies are available, and what employment tax burden the owner faces. The chapter walks through each major entity form—sole proprietorship, partnership, S corporation, and C corporation—explaining the structural differences, tax consequences, and planning implications of each.

The chapter also addresses how the One Big Beautiful Bill Act of 2025 changed entity planning by making the qualified business income deduction and individual tax rate brackets permanent, thereby strengthening the relative position of pass-through entities. It concludes with a framework for selecting an entity and guidance on restructuring when circumstances change, emphasizing that entity selection is an ongoing decision that should be reviewed annually.

In this chapter

• 9.1 The Entity Decision as Tax Decision — Business form determines tax treatment, and the choice should be deliberate, not accidental
• 9.2 The Default — Sole Proprietorship and Disregarded Entities — The simplest structure carries full self-employment tax with no entity-level shield
• 9.3 Partnerships and Multi-Member LLCs — Pass-through taxation with allocation flexibility but persistent SE tax exposure for active partners
• 9.4 The S Corporation Election — A tax election that enables the wage/distribution split, reducing employment tax on owner-operators
• 9.5 Reasonable Compensation — Shareholder-employee wages must be defensible or the IRS will recharacterize distributions
• 9.6 The C Corporation Alternative — Entity-level taxation creates double taxation but offers fringe benefits, retained earnings, and ownership flexibility
• 9.7 Entity Comparison Summary — A structured comparison of tax forms, rates, and features across all entity types
• 9.8 OBBBA Impact on Entity Planning — Permanent QBI deduction and rate brackets reshape the entity selection calculus
• 9.9 Restructuring — Changing Entity Classification — Conversion paths, costs, and tax consequences of moving between entity forms
• 9.10 The Entity Selection Process — A Framework — A six-step process for analyzing, documenting, and monitoring entity decisions

Key terms

• Self-employment tax — A combined 15.3% tax on net business earnings up to the Social Security wage base, imposed on sole proprietors and general partners
• Disregarded entity — A single-member LLC treated as a sole proprietorship for federal tax purposes, providing liability protection but no tax advantage
• Wage/distribution split — The S corporation strategy of paying reasonable wages subject to payroll tax while distributing remaining profit free of employment tax
• Reasonable compensation — The requirement that shareholder-employees receive wages appropriate for services rendered, enforced by IRS audit and case law
• Built-in gains tax (Section 1374) — A corporate-level tax on pre-conversion appreciation when a C corporation converts to S status and sells assets within the recognition period
• Pass-through entity — A structure where income, deductions, and credits flow through to owners without entity-level income tax
• Special allocations — Partnership provisions allowing income, gain, loss, or deduction items to be directed to specific partners, subject to substantial economic effect rules
• Qualified business income deduction (Section 199A) — A deduction of up to 20% of pass-through business income, made permanent by OBBBA

Who needs this chapter

Business owners choosing or reconsidering their legal structure, and practitioners advising clients on how entity form affects employment tax, income tax, and planning flexibility.