Updated: September 3, 2022
Tax liabilities differ based on the business type. It's important to understand the legal responsibilities your business structure holds with the Internal Revenue Service (IRS) so that you may be prepared for the proper tax paperwork requirements.
If you are interested in forming a business or have questions about your already established company, an Arizona business lawyer can help ensure your entity is compliant with state and federal regulations. Contact an attorney at Monahan Law Firm to ensure your business is structured properly and ensure you are protected today.
Types of Business Entities and Their Tax Forms
Below is a list of the four most common business entity types and their applicable tax forms.
A sole proprietor is an individual who independently owns and retains complete control of an unincorporated business. A sole proprietor does not have taxes automatically withheld from their income. This means a sole proprietorship will have to pay a self-employment tax and estimated taxes. They must also register for a federal employer identification number.
Self-employment tax includes something called the Self-Employment Contributions Act (SECA) tax and is filed with the IRS through Form 1040. SECA outlines that a self-employed person is responsible for the employer and employee portions of the Social Security and Medicare taxes. This tax is often paid quarterly along with an estimated tax payment.
Estimated tax payment is the estimated amount of income tax that should be withheld from an individual. In most circumstances, estimated tax should be paid quarterly to the government. The amount of income, type of income, and tax liability amount affect the obligation to pay quarterly. Speak to a tax accountant, or business attorney, or visit the IRS sole proprietorships page to learn more.
A partnership is a business that is owned by two or more people. Each partner in this business structure is entitled to a portion of the entity's profits and losses. The main types of partnerships are:
- General partnership - A legal arrangement where each partner shares the assets, profits, and liabilities of their business
- Limited partnership - A documented arrangement in which at least one partner shares unlimited liability and at least one limited partner shares liability only to the extent of their investment
- Joint venture - an arrangement that does not have to include only individual persons but could be between two different entities. Joint ventures are often short-term agreements that are based on a common goal and not on creating a profitable business. Each party retains its own personal assets, but both share legal liability.
Partnership agreements can be formed legally in order to protect individuals. Partnerships must report their incomes, losses, deductions, and credits to the Internal Revenue Service via tax Form 1065.
A limited liability company (LLC) is a business structure that allows investors, owners, and partners to limit their personal liability. LLCs offer small business owners the liability protection that benefits corporations, but also allow the business taxes to only be paid once through a member's income tax return. Ownership can be shared by multiple members or can be a single-member LLC.
The government will classify the LLC as a partnership or as a corporation. Generally, an LLC is viewed as a partnership but may elect to file Form 8832 to change its status to a corporation. The main benefit of listing as a corporation is that the owner is not responsible for all of the business income taxes and they do not have to pay a self-employment tax. If classified as a partnership, Form 1065 is used to file taxes. Form 1120 is used for those classified as a corporation.
A C-Corporation is a business structure where the owners and shareholders are taxed separately from the entity. C-Corporations allow an unlimited number of investors which makes it the applicable tax status for most larger companies. Using Form 1120, this business structure reports the income, credits, and deductions and the entity pays its own taxes.
Form 1120-S is used for tax filing for S-Corporations. S-Corporation status is used most applicably for small companies. In this structure, the owners have limited personal liability protection, so the shareholders and owners pay the taxes without paying additional federal tax on the company profits.
Pros and Cons of Tax Structures For Each Business Entity
One of the most common aspects that are determined as a pro or con depending on the type of business entity is the concept of double taxation versus pass-through tax entities. Double taxation means that the company pays tax on the profits and the shareholders and owners also pay personal taxes on their income or dividends. A pass-through entity structure means the owners and shareholders file a personal tax return, but do not file or pay taxes on the organization's profits directly.
The types of legal entities that utilize pass-through tax are sole proprietorships, partnerships, limited liability companies, and S-Corporations. None of these entities are responsible for corporate income tax. The profits of the entity "pass through" to the members or owners and are taxed on the individual income tax.
Of the four types of business entities discussed here, C-Corporations are the only ones that experience double taxation. Other types of corporations are also subject to double taxation. This means taxes on profits are paid from the business at the corporate level. Then when profits are distributed to the shareholders, they are taxed again on the individual income tax returns.
Beyond this generalization, there are individual pros and cons for each type of entity.
Related Content: Questions to Ask a Lawyer When Forming a Business
The main positive of this entity for tax purposes is that there is no separation between the owner and the business. Filing taxes is simple because everything, all expense, and personal income, are reported on a personal income tax return.
The main drawback of this structure is because there is no separation between owner and entity, the owner can be held liable for any legal action brought against the business. Also, sole proprietorships can not apply for a business loan.
Partnerships benefit from pass-through taxation. Meaning the individual partners pay taxes on the profits through their personal returns.
The risk of a business partnership is that the individual partners' personal assets do not always have limited liability protections. A limited liability partnership can modify its structure to assign different amounts of liability to different members.
Limited Liability Company (LLC)
For this legal structure, the biggest advantage is that the owner and business are seen as separate entities and the owner's personal assets are at a low-risk level. The only assets at risk are the business assets. The second main pro is that an LLC benefits from pass-through taxation.
The major con is that the liability is limited, meaning the owner is not protected in all instances. They still are at legal risk if they are sued by an employee or break intellectual property rights laws.
Learn More: Pitfalls When Forming an LLC
Again, the main benefit is pass-through tax. The owner withdraws their salary as an employee and the remaining profits are given as dividends to the corporate shareholders. Often times taxes on dividends are less than income taxes so the overall tax rate may be lower.
The process of forming and running an S-Corporation can be more costly and more complicated than the other structures.
As mentioned above, the main con of a C-Corporation is the double taxation effect. Also, C-Corporations are expensive to form and maintain. This is an option for large-scale enterprises that can afford tax advisors and legal help.
The pro of this structure is that everything is finely managed and clearly structured, making this business model more attractive to potential investors.
How to Know Which Business Entity is Right For You
The right legal structure for your individual situation greatly depends on the kind of service and size of the company. The corporate structure usually benefits large companies with many employees. Sole proprietorship, the simplest business entity, works best for freelance and independent contractors.
LLCs function well for individuals or entities with a few members or employees, usually in the field of professional services. Partnerships can work well for business partners who have other entities outside of the group. Also, consider the personal liability protection that is right for you as well as the tax burden you're willing to bear.
Get Legal Help Forming Your Business
An attorney can help you navigate the formation of your business and stay in compliance with state and federal government regulations. Legal counsel will be able to advise you on the type of business structure that is right for your concept while ensuring that you meet all reporting requirements and pay all necessary filing fees.
Running a business requires so much energy and effort, alleviate the stress of the legal process by hiring legal representation. At Monahan Law, we are dedicated to building long-term and personal relationships with our clients to support their success. Schedule a consultation with us today.