College of Entrepreneurial Studies (CES)
Of all the choices you make when starting a business, one of the most
important is the type of legal structure you select for your company.
Not only will this decision have an impact on how much you pay in taxes,
it will affect the amount of paperwork your business is required to
do, the personal liability you face and your ability to raise money.
The simplest structure is the sole proprietorship, which usually involves
just one individual who owns and operates the enterprise.
Advantages: The expenses and your income from the business
are included on your personal income tax return, meaning business losses
you suffer may offset the income you've earned from other sources.
Disadvantages: You're personally responsible for your company's
liabilities. Raising money for a sole proprietorship can also be difficult.
Banks and other financing sources are often reluctant to make business
loans to sole proprietorships.
If your business will be owned and operated by several individuals,
look at structuring your business as a partnership. Partnerships come
in two varieties: general partnerships and limited partnerships. In
a general partnership, the partners manage the company and assume
responsibility for the partnership's debts and other obligations.
A limited partnership has both general and limited partners. The general
partners own and operate the business and assume liability for the
partnership, while the limited partners serve as investors only; they
have no control over the company and aren't subject to the same liabilities
as the general partners.
Advantages: A partnership doesn't pay taxes on its income
but "passes through" any profits or losses to the individual
partners. At tax time, each partner files a Schedule K-1 form, which
indicates his or her share of partnership income, deductions and tax
Disadvantages: Personal liability is a major concern. Like
sole proprietors, general partners are personally liable for the partnership's
obligations and debts. Each general partner can act on behalf of the
partnership, take out loans, and make decisions that will affect and
be binding on all the partners (if the partnership agreement permits).
Partnerships are also more expensive to establish than sole proprietorships
because they require more legal and accounting services.
A corporation is an independent legal entity, separate from its owners,
and as such, it requires compliance with more regulations and tax
Advantages: A corporation's debt isn't considered that of
its owners, so you're not putting your personal assets at risk. A
corporation can also retain some of its profits without the owner
paying taxes on them. Another plus is the ability of a corporation
to raise money. A corporation can sell stock, either common or preferred,
to raise funds. Corporations also continue indefinitely, even if one
of the shareholders dies, sells their shares or becomes disabled.
Disadvantages: There are higher costs involved. Corporations
are formed under the laws of each state, each of which has its own
set of regulations. You'll probably need the assistance of an attorney
and accountant to guide you. And not only are corporations subject
to corporate income taxes at both the federal and state levels, any
earnings distributed to shareholders in the form of dividends are
taxed at individual tax rates on the owners' personal income tax returns.
The S corporation has some appealing tax benefits but still provides
business owners with the liability protection of a corporation.
Advantages: With an S corporation, income and losses are
passed through to shareholders and included on their individual tax
Disadvantages: S corporations are subject to many of the
same requirements corporations must follow, and that means higher
legal and tax service costs. They also must file articles of incorporation,
hold directors and shareholders meetings, keep corporate minutes,
and allow shareholders to vote on major corporate decisions. The legal
and accounting costs of setting up an S corporation are also similar
to those for a standard corporation.
Limited Liability Company
Limited liability companies, often referred to as "Lacs,"
are hybrid entities, bringing together some of the best features of
partnerships and corporations. "An LLC is a much better entity
for tax purposes than any other entity," says Ralph Anderson,
a CPA and small-business tax specialist with accounting firm M.R.
Advantages: LLCs were created to provide business owners
with the liability protection that corporations enjoy without the
double taxation. Earnings and losses pass through to the owners and
are included on their personal tax returns.
Disadvantages: The tax treatment for LLCs varies by state.
If you plan to operate in several states, you must determine how a
state will treat an LLC formed in another state. If you decide on
an LLC structure, be sure to use the services of an experienced accountant
who is familiar with the various rules and regulations of LLCs.