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.