The legal structure of your business

The legal form of business you choose when launching your company affects everything from your personal taxes to your legal liabilities and the ways you can raise capital. Here’s a closer look at the various options and their pros and cons.

1. Sole proprietorship: In a sole proprietorship, the most popular form of doing business, one person (you) owns and operates the business. The business’s income and expenses are both reported on your personal income tax return (Form 1040). Business profits and losses are reported using a Schedule C. You also file a Schedule SE that calculates your self-employmnet taxes. The advantages of a sole proprietorship: Your business earnings are taxed just once, and you alone are in charge of all business decisions. On the downside, as a sole proprietor you’re personally liable for any claims against your business, and you’ll likely find it harder to get financing. Many businesses start out as sole proprietorships and then move to another type of legal structure as they grow.
2. Partnership: A business with two or more owners can form a partnership. A general partnership means partners manage the company and are responsible for its debts. A limited partnership has both general partners and limited partners. The limited partners are simply investors, with no say in the company and no liability for debts. In most cases, a general partnership is the best choice for start-ups. A key advantage of partnerships is that the partnership itself doesn’t pay tax; profits or losses pass through to the individual partners, who report it on their tax returns. The disadvantage: As with sole proprietorships, all partners are personally liable for any debts or claims against the business.
3. Corporation: Incorporating protects you from personal liability for your company’s debts or claims against it. It also boosts your ability to raise capital, because the corporation can sell stock. The disadvantages: You will have to pay fees to file a corporation, and will probably need an attorney’s assistance. Because corporations are subject to greater regulation, you will have more ongoing costs, such as attorney and accountant fees. Finally, corporations are taxed twice: The corporation itself pays income tax, and the shareholders also pay taxes on any dividends they receive from the corporation.
4. S corporation: This form of business gives you protection from liability, like a corporation, but offers more tax benefits. Both income and losses pass through to shareholders and are reported on their individual tax returns; the S corporation itself does not pay federal taxes. And since S corporations can have as many as 100 shareholders, they also have an easier time raising capital. On the downside, S corporations have to deal with many of the same regulations and fees as corporations, so it costs more to form the S corporation and maintain it.
5. Limited liability company (LLC): This entity combines benefits of corporations and partnerships. An LLC gives you the same liability protection as a corporation, but without double taxation because earnings and losses are reported on the owners’ personal taxes. The LLC is similar to an S corporation, but has no limit on the number of shareholders, so you can have even more than 100. The form of business you choose will have great impact on your operations, both now and in the future, so it’s a good idea to consult an attorney before making this decision. And remember, your business structure isn’t set in stone. Reassess it every few years as your company grows to make sure you’re still using the most advantageous form of business for you.