Business Entity Forms

Many clients ask me about incorporating their businesses.  It is a pretty easy and inexpensive process, but it does require some planning.  Depending on the size, complexity and type of business you are engaged in, there are pros and cons to each entity type.  The forms of entity that are available include the sole proprietorship, partnership, corporation, s-corporation, and limited liability company.

If you don't file incorporation papers with the state, you will be considered a sole proprietorship. This means that you are the business.  You may have a separate checking account for the business, but there is no separate legal entity.  The income of the business is reported as income to you on a Schedule C to your tax return.  This is an easy way to operate, and many small businesses start out this way.  The main disadvantage of the sole proprietorship is that you have no liability protection if something goes wrong in the business.  If someone sues your business, your personal assets, such are your home, are at stake. 

If there are two or more people involved in the business, by default you are in a partnership.  Doing business as a partnership has many tax advantages. Income is taxed only once, and there is great flexibility in how income and deductions are passed through to the partners. But the partners' assets are put at risk, since each general partner is personally liable for the partnership debts and obligations.

Corporations don't have the liability problem, since shareholders aren't responsible for debts of the corporation. However, a corporation's income may be taxed twice, once when the corporation earns it and once when it is distributed to the shareholders in the form of dividends.  

Electing to be an s-corporation avoids double taxation. But s-corporations have many restrictions as to the number and type of shareholders, classes of stock, and ownership.   In spite of these restrictions, the s-corporation form is of particular benefit to self-employed individuals, because through proper planning you can avoid self-employment taxes on the portion of your income from the company that is not attributed to your salary.  

The limited liability company (LLC) is the form most commonly used by small businesses today.   An LLC is owned by investors known as members. It is managed either by the members themselves or by designated managers. Like shareholders of a corporation, the members' liability is limited to the amount of their investment. Yet, if the LLC is structured properly, it will be treated as a partnership for tax purposes. And there are no restrictions on the number and type of members, as there are with the shareholders of an s-corporation. 

Because of the numerous tax issues that are involved, you should consult an accountant prior to making any decision about incorporating your business.  You will also want to consult an attorney, particularly if you intend to start a business with someone else.  When multiple parties are involved in the business, you will want to make sure to structure the business so that the rights and responsibilities of each member or partner are spelled out in writing.  Although everything may seem great in the beginning, things may change and you will want to make sure there is an exit strategy in place if one of you decides to leave the company.