
When you start a business, you must decide on a legal structure for it. Usually you'll choose either a sole proprietorship, a partnership, a limited liability company (LLC), or a corporation. (Also, some businesses choose to operate as cooperatives.) There's no right or wrong choice that fits everyone. Your job is to understand how each legal structure works and then pick the one that best meets your needs. The best choice isn't always obvious. You may, after reading this section, decide to seek some guidance from a lawyer or an accountant.
For many small businesses, the best initial choice is either a sole proprietorship or, if more than one owner is involved, a partnership. Either of these structures makes good sense in a business where personal liability isn't a big worry -- for example, a small service business in which you are unlikely to be sued and for which you won't be borrowing much money. Sole proprietorships and partnerships are relatively simple and inexpensive to establish and maintain.
Forming and operating a corporation is more complicated and costly, but it's worth it for some small businesses. The main feature of LLCs and corporations that attracts small businesses is the limit they provide on their owners' personal liability for business debts and court judgments against the business. Another factor might be income taxes: You can set up an LLC or a corporation in a way that lets you enjoy more favorable tax rates. In certain circumstances, your business may be able to stash away earnings at a relatively low tax rate. In addition, an LLC or corporation may be able to provide a range of fringe benefits to employees (including the owners) and deduct the cost as a business expense.
Given the choice between creating an LLC or a corporation, many small-business owners will generally be better off going the LLC route. For one thing, if your business will have several owners, the LLC can be more flexible than a corporation in the way you can parcel out profits and management duties. Also, setting up and maintaining an LLC can be a bit less complicated and expensive than a corporation. But there may be times a corporation will be more beneficial. For example, because a corporation -- unlike other types of business entities -- issues stock certificates to its owners, a corporation can be an ideal vehicle if you want to bring in outside investors or reward loyal employees with stock options.
Keep in mind that your initial choice of a business form doesn't have to be permanent. You can start out as sole proprietorship or partnership and later, if your business grows or the risks of personal liability increase, you can convert your business to an LLC or a corporation.
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Ways to Organize Your Business
Type of Entity | Main Advantages | Main Drawbacks |
Sole Proprietorship | Simple and inexpensive to create and operate Owner reports profit or loss on his or her personal tax return |
Owner personally liable for business debts |
General Partnership | Simple and inexpensive to create and operate Owners (partners) report their share of profit or loss on their personal tax returns |
Owners (partners) personally liable for business debts |
Limited Partnership | Limited partners have limited personal liability for business debts as long as they don't participate in management General partners can raise cash without involving outside investors in management of business |
General partners personally liable for business debts More expensive to create than general partnership Suitable mainly for companies that invest in real estate |
Regular Corporation | Owners have limited personal liability for business debts Fringe benefits can be deducted as business expense Owners can split corporate profit among owners and corporation, paying lower overall tax rate |
More expensive to create than partnership or sole proprietorship Paperwork can seem burdensome to some owners Separate taxable entity |
S Corporation | Owners have limited personal liability for business debts Owners report their share of corporate profit or loss on their personal tax returns Owners can use corporate loss to offset income from other sources |
More expensive to create than partnership or sole proprietorship More paperwork than for a limited liability company, which offers similar advantages Income must be allocated to owners according to their ownership interests Fringe benefits limited for owners who own more than 2% of shares |
Professional Corporation | Owners have no personal liability for malpractice of other owners | More expensive to create than partnership or sole proprietorship Paperwork can seem burdensome to some owners All owners must belong to the same profession |
Nonprofit Corporation | Corporation doesn't pay income taxes Contributions to charitable corporation are tax deductible Fringe benefits can be deducted as business expense |
Full tax advantages available only to groups organized for charitable, scientific, educational, literary, or religious purposes Property transferred to corporation stays there; if corporation ends, property must go to another nonprofit |
Limited Liability Company | Owners have limited personal liability for business debts even if they participate in management Profit and loss can be allocated differently than ownership interests IRS rules now allow LLCs to choose between being taxed as partnership or corporation |
More expensive to create than partnership or sole proprietorship State laws for creating LLCs may not reflect latest federal tax changes |
Professional Limited Liability Company | Same advantages as a regular limited liability company Gives state-licensed professionals a way to enjoy those advantages |
Same as for a regular limited liability company Members must all belong to the same profession |
Limited Liability Partnership | Mostly of interest to partners in old-line professions such as law, medicine, and accounting Owners (partners) aren't personally liable for the malpractice of other partners Owners report their share of profit or loss on their personal tax returns |
Unlike a limited liability company or a professional limited liability company, owners (partners) remain personally liable for many types of obligations owed to business creditors, lenders, and landlords Not available in all states Often limited to a short list of professions |
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