Sole proprietorship. Sole proprietorships are the most common and easiest business structures to form. Sole proprietorships are only allowed for businesses with one owner, and there is no legal distinction between the owner and the business in a sole proprietorship. The main benefit is the ease of set up and that the income is reported on the owner's personal income tax return. It is important to understand that in a sole proprietorship, an owner’s personal assets are at risk and can be used to pay the business’ debts or obligations in the event the business fails, or if a lawsuit is filed.
Partnership. A partnership is owned by two or more persons. Similar to a sole proprietorship, a partnership is easy to form with minimal upfront costs. A partnership generally requires a written partnership agreement which is a contract between the partners describing how they will operate and potentially dissolve their business. Unless it is a limited partnership, the partners are personally liable for business debts. A partnership files a separate business income tax return, and each partner is given a Form K-1 to report that partner's share of the income on that partner's individual income tax return.
LLC (Limited Liability Company). LLCs have increasingly become popular. Created and governed entirely under state law, LLC owners must elect how they want to be taxed by the IRS (e.g. as a sole proprietorship, partnership, s-corporation, or even a c-corporation). LLCs limit the liability of the members, and are often a good way to protect assets. For example, holding a rental property within an LLC can minimize risk to personal assets in the event the renter files a lawsuit against the owner (LLC) of the property.
S-Corporation. S-Corporations require the working members to take wages from the business, unlike a sole-proprietorship or partnership. This means that the S-Corporation must file and pay quarterly payroll taxes, and issue W2s to those receiving wages. However, it has the advantage of lowering self-employment taxes by only taking a portion of the income as wages and the remainder as a dividend. Self-employment tax is 15.3%. For example, if the business net income is $300,000 and the owner pays himself wages of $180,000, the remaining $120,000 is not subject to self-employment tax resulting in a savings of $18,360. The warning here is that the wage paid to the owner must be "reasonable" given the facts and circumstances.
C-Corporation. This is by far my least favorite structure. First, if you organize as a corporation at the state level in Arizona you must file an annual report and pay an annual fee which is currently $45. The C-Corporation must file its own income tax return. Income is taxed at the corporation level and the tax rate is currently 21%. Any dividends paid to the shareholders are taxed again at the shareholder level. While it might seem attractive to some because of the 21% tax rate, the double taxation on dividends may make this less attractive. This is the only structure that does not qualify for the new Qualified Business Income Deduction which is another drawback.
At Prescott Tax and Paralegal we can give you information and tax advice on the different types of entities. The type of business entity is a question of both tax and law. We don't give legal advice, but we can give you information so that you can make an informed decision. Then we can help prepare the paperwork to correctly form your new business. We can prepare documents statewide. We would love to discuss your new business with you. To schedule a consultation, call us at 928-778-3113. Learn more about us at http://www.PrescottTax.com.
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