One question that always needs to be answered when starting a business is "What legal form of organization makes sense?" This may be a more important question than you think, as legal form can have significant implications on your personal risk in the business as well as your potential for financial returns. You will want to get some advice from an attorney prior to making a final decision, but what follows here are some issues that will help you understand the differences between forms.

Liability protection. The legal forms that you are likely to consider are sole proprietorships, partnerships, limited liability companies (LLCs), C-corporations, and S-corporations. You can generally rule out sole proprietorships and partnerships right away because of lack of liability protection. With these two forms, the business is not regarded as a separate legal entity from you, so your personal assets are part of the business. This means that if the business is sued for whatever reason, your personal assets are at stake. In a partnership, you have even more liability: your personal assets are on the line for anything that your partner may do. LLCs, C-corporations, and S-corporations are viewed as separate legal entities. What is at stake for you as an owner is what you have put into the business along with any personal guarantees you have made.

Business asset appreciation. A second aspect to consider is whether the assets of the business are likely to appreciate, or increase in value over time. If your business has appreciable assets, an LLC is likely a better legal form than a C- or S-corporation. When C- and S-corporations are terminated, assets are distributed to the owners and gains realized from appreciated assets (such as land) become taxable at a personal level. This tax obligation may preclude you from doing anything with those assets other than selling them to pay the tax. In an LLC, business assets are considered to be personal assets, and no distribution is recognized when the business is terminated. Therefore, no tax obligation would be realized until you actually sold the assets.

Active versus passive income. Another important tax issue for business owners relates to the earning of active versus passive income. Active income refers to your salary, or what you make from the business by performing job-related tasks. This portion of income is subject to Social Security and Medicare taxes, or employment taxes, which are about 15% (up to $87,000 of income). Passive income refers to dividend, rental, or royalty income from your business that you did not earn performing job-related tasks, and is not subject to employment taxes. As an example, if you started a small retail store and managed the store, your active income would be the salary of a comparable retail store manager and any income above that would be considered a dividend, or passive income.

In an LLC, you cannot distinguish between active and passive income, so you can end up paying significantly more in employment taxes than what you owe. For example, if income before tax for your retail store was $60,000 and your salary was $45,000, you would pay employment taxes on all $60,000 in an LLC even though you earned $15,000 in passive income (this is true even if you leave the $15,000 in the business and don't take it home). In contrast, in an S-corporation you could recognize the $15,000 as a dividend and only pay employment taxes on your salary of $45,000. You can also distinguish between the two in a C corporation, but dividends are paid after corporate taxes are taken out, so they essentially get taxed twice.

"Check the box" options in tax filing allow LLCs to elect to pay taxes as S-corporations (and distinguish between active and passive income), so it is not essential that you set up as an S-corporation from the start if you will have both active and passive income. But this is an important issue to understand and plan for, and setting up as an S-corporation may eliminate some confusion at tax time.

Retaining earnings in the firm. While most people think C-corporations are bad from a tax perspective because of the double taxation on dividends, there are instances where tax advantages exist when compared to LLCs and S-corporations. Income from C-corporations is taxed at a corporate rate, while that from LLCs and S-corporations is taxed at a personal rate. If you do some analysis of corporate tax rates versus personal tax rates at different earnings levels, you will find that in some scenarios the corporate tax rate is lower. So, if you are planning to retain earnings in the business to fund growth rather than take earnings out as dividends, you should investigate the tax differences and consider a C-corporation.

While this is not a complete set of considerations for choosing a legal form of organization, looking at these aspects will help you get started in the selection process. You will likely come to the conclusion that an LLC or S-corporation is right for your business, but do some research and hire a reputable business attorney that knows your state's laws. Doing your research ahead of time will save you money in your attorney's office, while getting a knowledgeable attorney will save you much more in the long run.


Got a comment on this topic? Post your thoughts in the Inc. Forums.