The Relationship Between Entity Types and Tax Classification: What You Need to Know

Distinguishing Between Entity Types and Tax Classifications

Many taxpayers often confuse entity types and tax classifications, not knowing the distinction between the two. To clarify this outlines the variances and their significance.

Key Points:

• There are four primary legal entities:

• Sole Proprietorship

• Small Member LLC

• Multi-Member LLC

• Corporation

Notably, Sole Proprietorship serves as both a legal entity and a tax classification.

Legal entities establish your business's identity and are established at the state level.

Your chosen legal entity dictates your tax classification, which, in turn, determines how the IRS taxes your business at the federal level.

Each legal entity defaults to a specific tax classification, but you can opt for a different classification by submitting relevant tax forms.

For instance:

• Sole Proprietorship and Small Member LLC default to Sole Proprietorship tax classification.

• Multi-Member LLC defaults to Partnership classification.

• Corporation defaults to C-Corporation classification.

None of the four primary legal entities automatically qualifies as an S-Corporation; you must file Form 2553 to elect S-Corporation status.

Depending on your selected legal entity, your default tax classification will be Sole Proprietorship, Partnership, or C-Corporation.

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