The first step when forming a US business is to decide what type of entity is the best form for the business (for example, a corporation, partnership, or limited liability company (LLC)). Which entity is the best form depends on structure, liability, management, and tax considerations. Non-tax factors usually are the primary considerations because in many instances an entity can choose how it is treated for tax purposes.

Businesses are generally formed under state law as (referred to as business entities in this Toolkit):

For tax purposes, a business entity is treated as one of the following:

The state law classification of a business entity is not always the same as the tax classification of a business entity. Under the check-the-box Treasury regulations, a business entity is classified either as a per se C-corporation or as an entity eligible to choose its tax classification (referred to as an eligible entity) (Treas. Regs. §§ 301.7701-2 and 301.7701-3).

A per se C-corporation is classified as a C-corporation for tax purposes and cannot make an election to be treated as a disregarded entity or partnership for tax purposes (Treas. Regs. §§ 301.7701-2 and 301.7701-3(a)). For example, a corporation incorporated under state law is a per se C-corporation for tax purposes. However, a per se C-corporation that meets the requirements for the S-corporation election (such as the requirements regarding the number, type, and residency of shareholders) can elect S-corporation tax status (IRC §§ 1361 and 1362).

By contrast, an eligible entity (meaning, a business entity not treated as a per se C-corporation) generally chooses its classification for tax purposes (Treas. Reg. § 301.7701-3). Partnerships and LLCs organized under state law are eligible entities under the check-the-box Treasury regulations. For example, a state law partnership can often elect partnership, C-corporation, or S-corporation tax status. Unlike partnerships and corporations, LLCs do not have a specific set of tax rules that apply only to LLCs. An LLC can often elect disregarded entity, partnership, C-corporation, or S-corporation tax status.

To understand the importance of the US federal income tax classification rules for US business entities, it is necessary to provide a brief overview of the tax rules that apply to disregarded entities, C-corporations, S-corporations, partnerships, and LLCs.

A business entity that is treated as a disregarded entity for tax purposes is an entity with a single owner that is generally ignored for tax purposes even though it is a separate legal entity for state law purposes. The owner of the disregarded entity is considered to own the assets (and is subject to the liabilities) of the disregarded entity for tax purposes and reports the entity's income and expenses on its own income tax return. In other words, a disregarded entity is treated like a sole proprietorship, branch, or division of the owner.

All corporations other than S-corporations are C-corporations. C-corporations generally are subject to two levels of tax on their income:

The relative inefficiency of two levels of taxation is somewhat reduced by the 21% corporate income tax rate that took effect in 2018. However, an eligible C-corporation generally can avoid double taxation by electing on formation to be treated as an S-corporation if it meets the Internal Revenue Code (IRC) requirements for an S-corporation election.

An S-corporation is a pass-through entity for tax purposes, which means it generally does not pay an entity level tax. The S-corporation's profits and losses instead generally pass through to its shareholders who include their respective share of those items on their income tax returns (whether or not distributed). However, there are significant limitations on the availability of the S-corporation election (for example, specific requirements regarding the number, type, and residency of shareholders).

Like an S-corporation, a business entity taxed as a partnership is a pass-through entity for tax purposes, which means it does not pay an entity level tax. The partnership's profits and losses are instead computed and allocated among the partners annually and pass through to the partners who include their respective share of those items on their income tax returns (whether or not distributed).

Unlike an S-corporation, a partnership does not have any restrictions on the number (other than the requirement that a partnership have two or more owners), type, or residency of its owners. Therefore, a business entity that desires pass-through taxation often chooses partnership tax status.

Even though an LLC is a recognized type of business entity formed under state corporate law, LLCs do not have their own US federal income tax regime. For tax purposes, an LLC is classified as a disregarded entity, C-corporation, S-corporation, or partnership. A single-member LLC is treated as a disregarded entity and a multiple-member LLC is treated as a partnership for tax purposes unless the LLC elects C- or S-corporation tax status.

This Toolkit provides a list of continuously maintained resources to help counsel understand the US federal income tax implications of choosing to operate a US business as a disregarded entity, C-corporation, S-corporation, partnership, or LLC.