Most Arizona small businesses should start with an LLC and consider the S-Corp tax election once profits consistently exceed $50,000 to $60,000 per year. A sole proprietorship works when you’re testing an idea, but it offers no liability protection and no real tax advantages.

A sole proprietorship is the default. If you start selling something or freelancing without filing any paperwork, you’re automatically a sole proprietor. There’s nothing to register and nothing to maintain. The problem is that your personal assets have zero protection from business liabilities. Someone sues your business and they can come after your personal bank accounts, your house, your vehicle. For anything beyond the most casual side income, this risk isn’t worth it.

An LLC is the right choice for most small businesses in Arizona. Filing with the Arizona Corporation Commission costs just $50, and Arizona doesn’t require annual reports. That makes it one of the cheapest and simplest states to form and maintain an LLC. You get a legal wall between your personal assets and your business obligations. For tax purposes, a single-member LLC is still treated like a sole proprietorship with everything flowing to your personal return. From contractors handling construction job costing in Phoenix to salon owners in Tempe, an LLC is typically the first real step toward running a legitimate operation.

The downside of a standard LLC is self-employment tax. You pay 15.3% on all net business income for Social Security and Medicare. On $80,000 in profit, that’s over $12,000 before income tax even enters the picture. This is where the S-Corp election becomes valuable.

An S-Corp is not a separate entity type. It’s a tax election you file with the IRS using Form 2553. You keep your LLC but choose to be taxed as an S-Corporation. The advantage is that you pay yourself a reasonable salary, and only that salary gets hit with payroll taxes. Profits above the salary pass through as distributions without the 15.3% self-employment tax.

Here is how the math works. Say your business nets $100,000. As a regular LLC, you pay self-employment tax on the full $100,000. With an S-Corp election and a $50,000 reasonable salary, you pay payroll taxes only on that $50,000 and take the remaining $50,000 as a distribution. That saves roughly $7,500 per year, and the savings grow as your profits increase.

But S-Corp status adds cost and complexity. You must run actual payroll, file quarterly payroll returns, and prepare a separate business tax return each year. Those compliance costs typically add $2,000 to $4,000 annually. Below $50,000 to $60,000 in net income, the tax savings usually don’t cover the extra expense.

A few Arizona-specific points worth knowing. The state has a flat 2.5% income tax rate regardless of entity type. On the federal side, the Qualified Business Income deduction lets you deduct 20% of qualified business income from your taxable income. For service businesses like medical practices, consulting firms, and salons, this deduction starts phasing out when taxable income exceeds $191,950 for single filers. How you split salary versus distributions under an S-Corp can affect your QBI deduction, so the entity decision isn’t purely about self-employment tax at higher income levels.

The right answer depends on your specific numbers. What you’re earning, what constitutes a reasonable salary in your field, and whether the added compliance costs make sense at your profit level. The general path for most Arizona small businesses is to start with an LLC and elect S-Corp status once the math clearly works in your favor.