The CDFI Lender’s Guide to Entity Types, Taxes, and Owner Pay
These foundational concepts shape how underwriters assess different businesses. Without a solid understanding of them, you’ll undoubtedly run into confusion at underwriting. This is designed to fix that: a definitive guide to business structures, taxation, and owner pay.
Business Formation & Governance Documents
Before you can assess a business's finances, you need to understand what kind of entity you're looking at, since that informs what formation, organizing, and tax documents you need to request from your borrower.
| Business Type | Legal Foundation Document | Internal Governance Document | IRS Tax Form |
|---|---|---|---|
| Sole Proprietorship | Trade / Assumed / Fictitious Business Name Registration / Certificate |
N/A | Schedule C |
| LLC | Articles of Organization | Operating Agreement / Partnership Agreement | Schedule C Form 1120-S Form 1065 |
| Corporation | Articles of Incorporation | Corporate Bylaws | Form 1120-S Form 1120 |
In practical terms, a Sole Proprietorship isn't really a business entity at all. It's what exists by default when someone operates a business without formally organizing one. There are no Articles of Organization or Incorporation, and there is no legal separation between the owner and the business. That’s why there's no governance document required and why income lands directly on the owner's Form 1040 via Schedule C. When you see a Sole Proprietorship, you're (technically) underwriting a person, not a company. As a result, it’s not possible for a Sole Proprietorship to have more than one owner (“sole” is right there in the name)!
LLCs and corporations, by contrast, are legal entities that exist separately from their owners. To establish an LLC or a corporation, articles must be filed with the Secretary of State. This provides some liability protection to personal owners as well as some tax benefits. However, it also comes with administrative burdens such as (sometimes) filing a separate tax return, paying annual fees to the Secretary of State, and having to maintain internal governance documents.
Helpful tip! Businesses are formed at the state level and not at the federal level. However, EINs (Employer Identification Numbers) are issued by the federal government, not state governments. As a result, you cannot use an EIN letter to verify the accurate legal name of a business nor that a business legally exists.
What’s the difference between a business’s formation document and its governance document?
Articles of Organization and Incorporation are formation documents. They are filed with the state and establish that a business legally exists. Formation documents are usually public record, and they confirm the basics: entity name, registered agent, entity type, and sometimes management structure. What they don't tell you is who owns what, how decisions get made, or how profit gets split. That's the job of governance documents: the Operating Agreement or Bylaws. These are internal documents usually not filed with the state or made public. Governance documents are where you'll find ownership percentages, voting rights, and profit allocations. The Articles tell you the business exists. The Operating Agreement or Bylaws tell you how it runs.
How Business and Personal Tax Returns Connect (and Don't)
Once you understand the type of entity you’re working with and how it is governed, you’ll likely turn to its tax returns next. The tax forms required depend on the legal entity type as well as how many owners there are. These forms, in turn, determine where taxes are levied: whether the business pays directly or its owners do.
| Entity Type | How it's Taxed |
|---|---|
| Sole Proprietorships Single Member LLCs |
The business tax return (Schedule C) is part of personal Form 1040. Tax is levied on the personal return. |
| Multi Member LLCs (aka Partnerships) | The business tax return (Form 1065) is separate from the personal Form 1040. Profits pass to each member via Schedule K-1 of the Form 1065 and are reported on Schedule E of the Form 1040. Tax is levied on the personal return. |
| LLCs taxed as S-Corps Corporations taxed as S-Corps |
The business tax return (Form 1120-S) is separate from the personal Form 1040. Profits pass to the owner(s) via Schedule K-1 of the Form 1120-S and are reported on Schedule E of the Form 1040. Tax is levied on the personal return. |
| Corporations taxed as C-Corps | Business (Form 1120) and personal (Form 1040) tax returns are completely separate. Tax is levied on the business return. |
For anything short of a full C-Corp, the business's tax outcome and the owner's personal tax outcome aren't separate; they're the same story told across two schedules. Only with a true corporation do business and individuals become genuinely distinct on paper as well as in practice.
As you can see in the table above, an LLC's default tax classification depends on how many members it has. Per IRS rules, an LLC with a single member is automatically classified as a "disregarded entity," meaning the IRS doesn't recognize it as separate from its owner for tax purposes. It files Schedule C. An LLC with more than one member is automatically classified as a partnership. It files Form 1065.
Either type of LLC can instead elect to be taxed as an S-Corp. To do this, the owner or owners must file paperwork with the IRS requesting the change. Without that election, member count for an LLC is what determines whether you're looking at Schedule C or Form 1065.
S-Corporation is a tax designation, not an entity type
If your CDFI’s loan application lists “S-Corp” as an option when a borrower selects what type of business they own, that needs to change. S-Corp is a tax election, not a legal structure. An LLC that elects S-Corp status is still legally an LLC; a Corporation that elects S-Corp status is still legally a Corporation. The election only changes how profit gets taxed and reported.
How Business Owners Pay Themselves
Once you understand what type of entity you’re dealing with (legally speaking), and how they pay taxes (fiscally speaking), you need to understand how the different legal and tax entities are permitted to pay their owners. As a lender, this helps you ask for the right documentation from the applicant when preparing a loan for underwriting (and helps you provide technical assistance to business owners who aren’t following the rules).
| Entity Type | Permitted Compensation |
|---|---|
| Sole Proprietorships Single Member LLCs |
Owner's draw (net profit) only. Neither a sole proprietor nor a single-member LLC owner can legally receive W-2 wages from their own business. |
| Multi Member LLCs (aka Partnerships) | Guaranteed payments and distributive share of profits. Members/Partners cannot receive W-2 wages; the IRS treats them as self-employed. |
| LLCs taxed as S-Corps Corporations taxed as S-Corps |
W-2 wages and shareholder distributions. This is the only structure that allows an owner to be on payroll and take distributions from the same entity. |
| Corporations taxed as C-Corps | W-2 wages (for owners who actively work in the business) and dividends paid out of after-tax profit. |
Note that the S-Corp election is the only door that opens W-2 wages to an owner who'd otherwise be barred from it, which is a big reason so many LLCs elect it.
Verifying Owner’s Distributions
If you’re working in the small business lending space, it’s critical that you understand: transfers from a business account to an owner's personal account cannot be conflated with owner’s draws, shareholder distributions, or dividends. A transfer just moves cash; it doesn't tell you whether that cash was a draw, a guaranteed payment, a distribution, wages, a loan, a reimbursement, or something else entirely. If you’re working with a business owner who pays themselves through profit distributions (which applies to every entity type except C-Corps), you need a P&L Statement or tax return to verify those draws—NOT a bank statement.
Conclusion
Entity type, tax treatment, and owner compensation aren't three separate topics. They're three layers of the same underlying structure:
The entity type determines which tax forms apply.
The tax forms determine how and where income is reported.
The tax treatment determines what kind of compensation the owner is allowed to take.
Once you can trace through all three layers, from formation documents down to the owner’s compensation, you'll have a far easier time knowing what documents to ask your borrower for, setting both of you up for success at underwriting.