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When you start a business, you must choose an ownership structure for it -- for example, whether it will be a sole proprietorship, partnership, corporation or limited liability company (LLC).
There's no one choice that fits every business; your job is to pick the form that best meets your needs. This article introduces several of the most important factors involved in picking the right legal structure for your business, including:
the potential risks and liabilities of your business
the formalities and expenses involved in establishing and maintaining the various business structures
your income tax situation, and
your investment needs.
In large part, the best ownership structure for your business depends on the type of services or products it will provide. If your business will engage in risky activities-- for example, trading stocks or repairing roofs -- you'll almost surely want to obtain liability insurance and form a business entity that provides personal liability protection, which shields your personal assets from business debts and claims. This means setting up a corporation or limited liability company (LLC).
Sole proprietorships and partnerships are easy to set up -- you don't have to file any special forms or pay any fees to start your business. Plus, they don't require you to follow any special operating rules.
LLCs and corporations, on the other hand, are not as easy to set up, but do offer added potential benefits. To form an LLC or corporation, you must file a document with the state and pay a fee. In addition, owners of corporations and LLCs must elect officers (usually, a president, vice president and secretary) to run the company, and they must keep records of important business decisions and follow other formalities.
When it comes to taxes, sole proprietorships, partnerships and LLCs come out about even. These three business types are "pass-through" tax entities, which means that all of the profits and losses pass through the business to the owners, who report their share of the profits (or deduct their share of the losses) on their personal income tax returns. Therefore, sole proprietors, partners and LLC owners can count on about the same amount of tax complexity, paperwork and costs.
One thing to bear in mind is that owners of these unincorporated businesses pay income taxes on all net profits of the business, regardless of how much they actually take out of the business each year. Even if all of the profits are kept in the business checking account to meet upcoming business expenses, the owners must report their share of these profits as income on their tax returns.
Unlike other business owners, the owners of a corporation do not report their shares of corporate profits on their personal tax returns. The owners pay taxes only on profits paid out to them in the form of salaries, bonuses and dividends.
The corporation itself pays taxes, at special corporate tax rates, on any profits that aren't deductible -- that is, profits that are left in the company from year to year (called "retained earnings") and dividends (portions of profits that corporations sometimes pay out to shareholders in return for their investments). This separate level of taxation adds a layer of complexity to filing and paying taxes, but it can be a benefit to some businesses.
Not only do owners of a corporation avoid paying personal income taxes on profits they don't receive, but because federal corporate income tax rates on a portion of corporate income are lower than the federal individual income tax rates on that same amount of personal income, a corporation and its owners may actually pay fewer overall taxes than owners of unincorporated businesses. You will want to discuss your personal tax situation with your CPA or tax adviser in detail prior to selecting any business entity.
Corporations -- unlike other types of business structures -- provide a built-in stock structure that makes it easier to attract investment capital, including the possibility of raising capital by making an offering of shares. In addition, this stock structure allows businesses in the Internet and other hot technology industries to attract and retain key employees by issuing employee stock options.
But for businesses that don't need to issue stock options and will never "go public," forming an LLC may be more practicable. If it's limited liability that you want, an LLC provides the same protection as does a corporation, but with more flexibility.