Choosing the Right Entity in 2026: Tax Implications for Small Businesses

If you run a small business, choosing the right entity type isn’t just a legal checkbox — it’s a strategic decision that affects how much tax you pay, how much you keep, and how your business can scale.

With the tax-landscape shifting under One Big Beautiful Bill Act (OBBBA) and with 2026 around the corner, now is the time to revisit your structure and ask: “Is what I started with still the best fit?”

Why structure even matters

Imagine you’re keeping the same business but changing hats — from sole proprietor to S-Corp. Same clients, same revenue, maybe same staff, but the tax outcome changes. Entity selection affects:

• How your business profits are taxed (pass-through vs corporate)
  
• Whether your owners pay self-employment tax or less
  
• How retirement plans, deductions, and future sale proceeds are handled
  
• Your audit exposure, compliance burden and flexibility
  

In short: your entity impacts your cash flow, tax bill, and growth options.

What’s changing in 2026 and why it matters

The OBBBA didn’t flip the world of entity choice upside down, but it added important new layers worth modelling. According to a recent industry insight piece, business owners should “reassess what type of entity … can provide the most significant tax advantages” given the new rules. CBIZ+2barley.com+2

Here are key change-drivers:

• The 21 % federal corporate tax rate (for C-corps) stays permanent. Financial Planning Association+1
  
• The 20 % qualified business income (QBI) deduction for pass-throughs is now permanent for eligible taxpayers. Financial Planning Association+1
  
• Energy and equipment deductions, reporting rules and business credits have shifted — which can affect logically how you structure compensation, investment and growth. National Law Review+1
  
• State-level tax conformity continues to be a wild card — meaning your federal best practice may need tweaks based on where you operate.
  

In short: The optimal entity for 2024 might not be the optimal one for 2026. That means modelling matters, not just picking “LLC because everyone does.”

The main entity types — pros and cons

Below is a rundown of the most common structures for small businesses, with their tax pros & cons under the current (and upcoming) environment.

Sole Proprietorship (or Single-Member LLC taxed as disregarded)

Pros:

• Simple setup and minimal formalities
  
• Profits taxed directly to owner at personal rates
  Cons:
  
• Owner pays self-employment tax on business income
  
• No distinction between personal and business liability
  
• Less flexibility for retirement plans, equity compensation
  

Limited Liability Company (LLC)

LLCs can elect to be treated as a sole proprietorship (for single-owner), a partnership (for multi-owner), or a corporation (C- or S-) for tax purposes. (See IRS “check-the-box” rules.) 

Pros:

• Flexible ownership structure
  
• Limited liability protection for owners
  
• If taxed as S-Corp: ability to take salary + distributions (which can reduce self-employment tax)
  Cons:
  
• S-Corp election must meet eligibility rules
  
• Complexity and cost might increase as you scale
  

S Corporation

Pros:

• Pass-through taxation, meaning business profits bypass corporate tax and get taxed on owner’s personal return
  
• Potential savings on self-employment tax if you take reasonable salary + distributions
  Cons:
  
• More IRS scrutiny around “reasonable salary”
  
• Eligibility limitations (e.g., one class of stock, max 100 shareholders)
  
• Distributions must be properly documented
  

C Corporation

Pros:

• Flat 21% corporate tax rate (now permanent) Financial Planning Association
  
• Retained earnings inside the business for growth investments
  
• Potential for qualified small business stock (QSBS) benefits under OBBBA (for eligible companies) CBIZ
  Cons:
  
• Double taxation (corporate profits taxed + dividends taxed)
  
• Less straightforward for owner-tax strategies unless you plan a sale or large expansion
  

How to pick the right entity for your stage and goals

Choosing the “right” entity is not about a generic “this is best” rule — it’s about matching YOUR business parameters to a structure. Here are questions to guide that decision:

1. What is your expected profit and cash flow this year and next?
   If you expect high income and want to optimise tax, pass-throughs may give more flexibility.
   
2. Do you expect to retain most profits in the business for growth, or distribute to owners?
   C-corp might fit if you retain earnings; S-Corp/LLC if you distribute.
   
3. Are you considering raising capital, offering equity, or planning an exit?
   QSBS eligibility (for C-corps) now improved under OBBBA — may tip decision. CBIZ
   
4. How much administrative burden and cost can you absorb?
   More complex structures (S-Corp, C-Corp) require more compliance.
   
5. What state are you in?
   State tax rules matter. Pass-through states vs corporate tax states change the equation.
   
6. Do you have employees or plan to hire?
   Some entity types simplify payroll, benefits, retirement plan setup better than others.
   

Real-world scenarios

Scenario A — Early Stage Service Business (Founder working solo)

• Business income: $180K
  
• Plan: Minimal fixed assets, all income is distributed
  
• Recommendation: LLC taxed as S-Corp
  
  • Take a “reasonable salary” (e.g., $100K)
    
  • Distribute remaining profits (e.g., $80K) without self-employment tax
    
  • Benefit from QBI 20% deduction (if eligible)
    

Scenario B — Growing Product Startup with VC ambition

• Income: $0 this year, expecting ramp next few years
  
• Plan: Retain profits for R&D and reinvest
  
• Recommendation: C-Corporation
  
  • Use 21% rate on retained earnings
    
  • Position for QSBS exclusion on exit (OBBBA improved thresholds)
    
  • Avoid personal immediate distributions which may incur higher rates
    

Scenario C — Family-owned business shifting to next generation

• Income: $500K, but retirement plan in place, owners want succession-friendly structure
  
• Recommendation: LLC with multi-member treaty considerations
  
  • Use partnership flexibility for profit allocations
    
  • Consider S-Corp if profit patterns stable
    
  • Model state tax impacts
    

What changed under OBBBA that shifts entity modeling

Several provisions under OBBBA have special relevance for entity selection:

• Permanent 20% QBI deduction for eligible pass-through businesses. barley.com+1
  
• Expanded QSBS exclusion thresholds, making C-corporation more attractive in certain growth scenarios. CBIZ
  
• New or modified credit and deduction rules (equipment, energy) influencing whether profits should be inside or distributed. National Law Review
  

Implication:
Pass-throughs may still win for many small businesses, but if you’re scaling fast, retaining earnings and planning for an exit, a C-corp may no longer be the default second choice — it could be the first choice. That makes modeling critical.

Implementation checklist — what to do now

•  Review your 2023-24 tax returns and projected 2025 income.
  
•  List your top 3-5 business goals for 2026 (e.g., hiring, capital raise, reinvest profits).
  
•  Run entity modelling: compute owner taxes under LLC/ S-Corp/ C-Corp scenarios.
  
•  Check state tax impact based on your domicile and operations.
  
•  File entity election forms if changing (e.g., Form 8832, Form 2553) and track deadlines.
  
•  Document material decisions for your files (capital structure, salary/distribution policy, board resolutions).
  
•  Review compensation strategy to meet “reasonable salary” rules for S-Corps.
  
•  Revisit retirement plan eligibility and deduction limits under chosen structure.
  
•  Plan a revisit date for entity decision (structures evolve and your business may outgrow your choice).
  

Mistakes to avoid

• Choosing an entity just because peers use it. One size doesn’t fit all.
  
• Ignoring “reasonable salary” rules. Owner salaries too low in an S-Corp can trigger IRS scrutiny.
  
• Changing entity without modelling future years. Some benefits (like QSBS) play out in exits, not just year-end.
  
• Neglecting state tax rules. You may pick the best federal entity but pick a state unfriendly to that type.
  

Assuming C-corp growth means liquidity. Without exit planning or dividend strategy, double taxation can hurt.

Ready to optimise your finances and maximise your deductions? Book a Tax Planning Consultation with MyTaxFiler today.