By Colleen Debaise, Small business editor, The Wall Street Journal
The best entity for you will depend on the type of business you'll run, your potential exposure to lawsuits, the number of owners and whether you want the ability to raise capital or transfer shares. It's smart, and in many cases necessary, to consult a lawyer or accountant when making your choice. You may also take advantage of a number of resources available on the Internet, including LegalZoom.com and Nolo.com, which offer legal forms and do-it-yourself kits at reasonable prices.
The vast majority of small businesses start off as sole proprietorships, which are the simplest and least expensive vehicles to create and operate, according to the SBA. With a sole proprietorship, the owner and the business are essentially one and the same, meaning you have complete control, you can make decisions as you see fit and the profits from the business flow through to your personal tax return as Schedule C income. (If you don't have profits, you may be entitled to a business loss that can help offset other income.) To launch a sole proprietorship, you don't need to file legal forms or paperwork, such as articles of incorporation, but you might have to obtain a business license, depending on state law. A sole proprietorship can only be used by an individual who owns the company, unless it's a husband- and- wife team, in which case it can be shared.
When two or more people (not spouses) start a business together, a sole proprietorship isn't an option. Instead, the owners may form a general partnership, which is much like the sole proprietorship in that it can be established easily and requires minimal cost or paperwork (some states might require a basic partnership certificate stating the partners' names, aside from other business licenses). The profits from a partnership flow through to the partners' personal income tax returns. Partners may split profits equally, or decide one or more partners deserve a greater share for contributing either more assets or work hours to the business. Each partner then pays self- employment taxes on his or her share.
Also like a sole proprietorship, a general partnership doesn't protect against personal liability— and in addition, partners are held responsible for the actions of the other partners. But perhaps the greatest risk with a partnership is the possibility of disagreement and, along with that, disappointment and frustration that can threaten the livelihood of the business. When two or more people start a company together, it's wise (but not legally required) for them to craft a written, carefully thought- out partnership agreement. Much like a prenuptial agreement, the partnership agreement spells out who brings what to the relationship, such as cash or property, and outlines what happens if either partner wants out, dies, becomes disabled or stops performing. Options, such as a buyout or sale of the partner's interest, should be included in a buy- sell clause or, if complex, in a separate agreement.
Many partners, especially those starting retail or service businesses, will choose to establish a general partnership, although they might also consider forming an LLC or corporation to protect liability, receive different tax treatment or other reasons. In addition, two other but less common partnerships are outlined below.
A more formal and complex arrangement than a general partnership, the limited partnership has one or more general partners who make management decisions and one or more limited partners who are passive investors. While the general partners are personally liable for the debts of the venture, the limited partners are liable only to the extent of their investment. An LP may be appropriate for a small but growing business that wants to raise money by selling limited partnership interests in the company.
Limited Liability Partnership
With this vehicle, partners are liable for the company's business debts and for their own negligence, but not the negligence of other partners. The LLP is commonly used by doctors, lawyers and other professionals who want to establish a practice together.
The C Corporation
The regular or C corporation is considered a legal entity that's completely separate from the owner or owners who create and manage its operations. The most common reason for setting one up is to protect your personal assets (such as your home, investments or retirement accounts) from any business-related liabilities; if the corporation goes belly-up, owners (called shareholders) lose their investment but won't be held liable for any debt owed to the company's creditors. Also, each owner is responsible for his or her own personal negligence or misdeeds but not that of co-owners.
Corporations issue stock and are run by a board of directors (or, in smaller companies, a single director) who oversee major decisions and operating procedures. The issuance of stock makes it easier to attract investors and high-caliber employees, who may be motivated by the chance to own a piece of the company.
A drawback to forming a C corporation is the so-called double taxation of corporate profits. Because it's a separate entity, the corporation pays taxes at the corporate rate on all income that's left after business expenses (including salaries) are paid. That income is taxed again when it's distributed as dividends to owners (shareholders) at their own individual income tax rate. To avoid double taxation, some owners prefer to set up an S corporation. The C corporation does provide some tax advantages, however. For instance, if you want to keep profits within the company for growth or expansion, rather than paying them out, the money may be taxed at a lower corporate rate than what you would pay as an individual.
Corporations take time and money to set up, and it's best to consult a lawyer familiar with the formalities of creating and maintaining such an entity. You'll need to pay a filing fee (which varies by state) and prepare a document called the articles of incorporation. Check the website of your state's secretary of state for a fill-in-the-blank form. Generally, you need to adopt bylaws, appoint officers and directors and hold annual meetings, although many states allow smaller corporations to operate in a less formal manner.
The limited liability company, or LLC, is a relatively new entity that has become a popular choice among small business owners because it offers liability protection, flexibility and tax efficiency, according to Alan C. Ederer, a partner at Westerman Ball Ederer Miller & Sharfstein, LLP, in Mineola, N.Y., who advises his business-owner clients on the LLC.
With an LLC, your liability is generally limited to how much you put into the company, so you're not responsible for the company's debt beyond your personal investment, with the exception of any business debt you personally guarantee, such as a business loan or line of credit, or any misdeeds that you personally commit, for which you are also on the hook.
The management structure of an LLC is less formal than that of a corporation, so owners can freely divvy up operational duties and don't need to keep minutes, pass resolutions or hold annual meetings. More important, the structure allows for the same passthrough taxation of sole proprietorships, partnerships and S corporations. That means owners avoid the C corporation's double tax trap.
Of course, forming an LLC is not quite as easy as a sole proprietorship or partnership. You'll need to prepare articles of organization, which are generally filed with your state's secretary of state. Some states provide fill-in-the-blank forms, requesting standard information such as the LLC's name, business purpose and type of management (such as membermanaged, where all owners take part in management, or manager- managed, where some owners manage while others act as passive investors). Some states may ask for an operating agreement, which, much like a partnership agreement, outlines each owner's responsibilities, his or her share of profits or losses, and what happens if any owner wants out. Even if your state doesn't legally require one, it's wise to have an operating agreement to avoid or resolve any problems that may arise. For more on what your state requires of an LLC, visit the website of your state's secretary of state.
An LLC can also be suitable for the single owner who wants the liability coverage of a corporation but the more simplified tax treatment and operational freedom of a sole proprietorship. The LLC is often described as a hybrid vehicle that maximizes the advantages of other structures while minimizing the disadvantages.
For more help in deciding which structure is the best fit for your business, check out a helpful resource on the SBA's Web site, the choose-a-structure feature. In addition, the IRS's site outlines the income tax forms you'll need to file based on your business structure. Before proceeding to create any type of business structure, consult with your attorney and other relevant professionals, such as your tax advisor or accountant. There are complex legal and tax issues involved, and you'll want to make sure you've made the wisest choice for your new business.