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Choice of Business Entity

Having made the decision to establish a new business or to expand an existing one, among the first questions to be answered is which type of business entity best suits the situation. Today there are several choices in Arizona and in most states.  Among the most prominent factors to be considered are limited liability and income tax treatment of the business and its owners. Corporations provide liability protection to investors (shareholders), whose financial risk is limited to the amount they invest regardless of the size of the debt of the business (unless the shareholders personally guaranty corporate debt).  This liability protection also applies to non-contractual liability such as tort (e.g. personal injury) liability, so it is an important consideration even for a small business where the owners are required by lenders to guaranty business debt.

Under current tax law income tax is paid by individuals and by corporations, so the initial decision is whether income tax should be paid by the business itself as corporate tax, or whether the business owners should report and pay the tax on their respective shares of the business income.  The federal and state income tax laws have made it generally unattractive for small businesses to be taxed as corporations; so-called “C” corporations because the provisions of the Internal Revenue Code applicable to them are in Subchapter C.  Income taxed to “C” corporations is potentially taxable a second time to the owners of business, if and when it is distributed, resulting in double taxation. In addition, growth in the value of the “C” corporation business is often subject to double taxation when a business is sold.

The alternative tax treatment is for the owners to pay the tax on the business income as it is earned.  The business entity forms which provide this tax treatment are sole proprietorship (one owner), partnership (general or limited), limited liability company (LLC) and “S” corporation.  Like the “C” corporation, the “S” corporation receives its name from the particular subchapter of the Internal Revenue Code applicable to it.  The “C” corporation and “S” corporation are identical with respect to the corporate law applicable to them.  Both are merely “corporations” formed under state law, but the “S” corporation files an election to be taxed under subchapter S, rather than subchapter C.

Although in most respects an “S” corporation is taxed in much the same way as a partnership or limited liability company (both under Subchapter K), there are some very significant differences and there are numerous restrictions for qualification to make the “S” corporation election.  On the other hand, there are few “S” corporation benefits, the most prominent of which is that an owner can be considered an employee for self-employment tax purposes.

For these reasons the vast majority of small businesses being formed today are limited partnerships and limited liability companies, with limited liability companies (“LLCs”) predominating.

The LLC is a comparatively new form of business entity, having been established to provide the same liability protection as a corporation and the tax treatment of a limited partnership without the requirement of a general partner who would not have liability protection.

Under Subchapter K, partnerships and LLCs pass through to partners (in the case of partnerships) and members (in the case of LLCs) their respective percentages of income and expense items which the partner or member reports on his or her individual income tax return.  The result is that the partner or member is taxed much like a sole proprietor with respect to that portion of the business.  From a reporting standpoint, the member shareholder receives a Form K-1 from the entity and reports net income/loss and certain other items directly on his Form 1040 (Schedule S), rather than on Schedule C.

For liability protection purposes, many business and real estate owners are forming LLCs even when there is only one owner.  Single member LLCs are disregarded for tax purposes and income is reported as sole proprietorship income.

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