What’s the Difference Between Entity Types and Tax Classifications?

If you’re a business owner, you may have wondered about the difference between a legal entity and a tax classification. It’s a common area of confusion, and knowing the distinction can make a big difference in how your business operates and is taxed. Here’s a quick breakdown to help clarify:

  1. Legal Entities
    Think of a legal entity as the official structure of your business. This structure is set up at the state level and includes some common types like:
  • Sole Proprietorship
  • Single-Member LLC
  • Multi-Member LLC
  • Corporation

(While there are more than just these four, they’re the ones business owners most frequently ask about.)

  1. Tax Classifications
    Tax classifications, on the other hand, are assigned by the IRS and affect how your business is taxed at the federal level. The main classifications include:
  • Sole Proprietorship
  • S-Corporation
  • C-Corporation
  • Partnership

Why the Confusion?
You may have noticed that “Sole Proprietorship” appears on both lists. That’s because it can serve as both a legal entity and a tax classification. But here’s the key: legal entities identify your business structure at the state level, while tax classification determines how it’s taxed by the IRS.

Understanding Default Tax Classifications
Each legal entity has a default tax classification:

  • Sole Proprietorships and Single-Member LLCs are usually taxed as Sole Proprietorships
  • Multi-Member LLC defaults to Partnership
  • Corporation defaults to C-Corporation

How About S-Corporation?
An S-Corporation isn’t a default tax classification for any legal entity. To be taxed as an S-Corp, you need to file IRS Form 2553. Without this, your business defaults to either Sole Proprietorship, Partnership, or C-Corp depending on your entity type.

So, if you’re thinking about forming a business or reviewing your current setup, understanding these basics can help you decide the best path forward.

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Warm regards,
Shemea Broom
Owner, Sapphire Tax Notary
Phone: 205-235-2373
Email: mea@sapphiretaxnotary.com