HOW TO INCORPORATE

What Kind of Business Should Your Business Be?

The form of incorporation you choose will affect the taxes you pay, who can invest in your company, and your financial security.
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If you're starting a business, one of the first questions you need to answer is what kind of business you're going to be. By this, I don't just mean what kind of products you'll sell or service you'll provide, but what legal form your business is going to take.

Now, this may sound like a question that shouldn't be very important to a very small business. After all, if you're going to be a consultant or a graphic designer or an electrical contractor, why bother dealing with the government? Who needs to pay a few hundred dollars in corporation or legal fees?

But choosing a legal form affects how much you pay in taxes, who can invest in your company, and most importantly, your personal financial security.

Three things to keep in mind when choosing a legal form are:

  • Liability: Legally, corporations are individual entities. As such, the corporation -- not individual shareholders -- are responsible for the actions of the business. In other words, if something goes very wrong, and a corporation is sued, only the assets of the corporation are at stake -- not the owners' personal assets. (There are some exceptions to this rule, but generally, your personal liability is GREATLY limited.)
  • Double taxation: No one likes paying taxes, and you certainly don't want to pay taxes twice -- once on income for the business and then again when that income is distributed as profits to you. Instead, look for a legal form that allows for the profits of the company to "pass through" to the owners, without having to pay corporate taxes first.
  • Ownership: Certain legal business forms limit the number or type of people who can invest in your company. If you're seeking a large number of investors or international investors, find a corporate structure that permits such stockholders.

It's always best to sit down with an attorney -- and possibly an accountant -- to discuss the best corporate structure for your specific business.

When you do meet with an attorney, these are the legal structures you'll consider:

  • Sole Proprietorship: A business owned by one person with no formal legal structure.
    Advantages: It's simple! Just start your business; there's no additional paperwork. You don't file corporate income taxes -- just a Schedule "C" with your personal income taxes.
    Disadvantages: You have no personal liability protection. If your business is sued, you could lose everything you own -- and in some cases, your spouse could lose his or her assets also.
  • Partnership: A business with more than one owner who actively engages in the management of the company.
    Advantages: No required legal forms (although you'd be well advised to draw up a partnership agreement). No double taxation -- profits pass through to the partners.
    Disadvantages: Each partner has unlimited personal liability, even for actions taken by other partners. Be warned: if you go into business with others, you've got a partnership in the eyes of the law whether or not you've drawn up any paperwork.
  • Limited Liability Company (LLC): A legal form which provides liability for the company's owners without requiring incorporation. LLCs have become the form of choice for many small companies.
    Advantages: Personal liability protection for all owners and pass through profits without corporate taxes. Another benefit: profits can be distributed unequally -- a 60% shareholder can take only 10% of the profits. This allows more flexibility for tax planning and for rewarding owners who bear more management responsibilities.
    Disadvantages: LLC laws vary by state; you are likely limited in the number of owners (investors) you can have, and some states do not permit international investors.
  • "S" Corporation: A type of corporation that provides personal liability but permits pass through taxation.
    Advantages: This used to be the most popular choice for small companies, and lawyers and accountants are very familiar with laws relating to S corporations.
    Disadvantages: You can not distribute profits unevenly as you can with LLCs. You pay state corporate fees.
  • "C" Corporation: A corporate form that allows for the most investors and significant liability protection.
    Advantages: No limit to the number of people who can own stock. Legal form for companies that are going to be publicly traded.
    Disadvantage: Double taxation.

Copyright Rhonda Abrams, 2003


Rhonda Abrams is the author of The Successful Business Plan: Secrets & Strategies and the president of The Planning Shop, publisher of books and tools for business planning. Register for her free business-planning newsletter at www.PlanningShop.com.

Last updated: Sep 1, 2003




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