The Pros and Cons of the Various Legal Business Structures

You face an endless array of decisions before starting a new business, such as choosing the right name, the right location and the right technology.  But probably the most important decision, at least in terms of taxation, is the type of legal entity you select.

Aside from taxes, the type of business entity also impacts the amount of paperwork you’re required to do and the personal liability you could encounter. For instance, did you know that operating as a sole proprietorship -- the simplest and most common business form - means that creditors can go after your personal assets to collect payments associated with your business?

One thing that might help relieve some of the pressure over which entity to choose is the fact that you can change structures. For example, if you initially organize as a sole proprietorship, you can reorganize into an S corporation or other business entity at a later point.  Just be sure to work with your tax and legal advisors if you want to change your business structure.

To help you better understand the key differences, a brief description of each entity follows.

Sole Proprietorship

If you are the only owner, you can choose to operate your business as a sole proprietorship. (It is also possible for spouses to conduct a single business as a sole proprietorship.) For federal income tax purposes, you report your business income and expenses on Schedule C, which is an attachment to your personal income tax return (Form 1040). Net earnings from the business are subject to both self-employment and income taxes.  One significant issue for a sole proprietorship is the lack of liability protection. The sole proprietor's personal assets can be used to satisfy the claims of business creditors.

Corporation

A corporation is a separate legal entity that transacts business in its own name. Although a corporation can be large and have thousands of shareholders, even a small business with one owner can incorporate.

C corporations 

• The corporation files its own income tax returns and is a separate taxpayer.  It applies a corporate tax rate schedule to compute its taxes each year.
• The two principal ways that an owner takes money out of a corporation are through salary payments and dividend distributions. Generally, the owner's salary may be deducted by the corporation as a business expense. The corporation can also choose to distribute corporate earnings as dividends to the owner. However, the income will be taxed a second time to the owner, and the corporation will not receive a deduction for the dividend distributions.
• Assets of the corporation are separate from those of the owner, so creditors can generally look only to the corporate assets for satisfaction of their claims.

S corporations 

• An S corporation offers the limited liability of a corporation without the double taxation associated with dividend distributions. The S corporation files income tax returns but generally does not pay federal income taxes itself. Instead, the owner is taxed individually on his or her respective share of the corporation's taxable income.
• When S corporation shareholders perform services for the entity, the IRS may treat dividends paid in lieu of reasonable compensation as wages subject to employment taxes.

Partnership

A partnership has two or more owners. It must have at least one general partner who is liable for the partnership's debts and obligations, though other investors may limit their potential liability by taking limited partnership interests.

Partnerships do not pay federal income taxes but must file an informational return with the IRS. Profits and losses are divided among the partners according to the terms set forth in the partnership agreement and are taxed to the partners individually.

Limited Liability Company

A limited liability company (LLC) is a separate legal entity that can have one or more owners (called members). Depending on the elections made by the LLC and its members, the LLC will be treated as a corporation, a partnership, or as part of the LLC owner's individual tax return.

Like an S corporation, an LLC affords both liability protection and pass-through taxation.  It also offers more flexibility in terms of allocations of special tax benefits and allowable ownership interests.