When you decide to start your own business, there are many decisions to make. A critical decision is to decide what legal or formal structure the business will take. This is important because if you desire to work with wholesale suppliers or establish business credit, you will need to prove that you are a legitimate business. There are four forms your business can take: sole proprietorship, partnership, S-Corporation, and limited liability company. (There is also another corporate entity, the C-Corporation, but this structure is not often used by small businesses and will not be discussed here.)
A sole proprietorship is the simplest form your business can take. It has a very simple legal structure and you must get a business license from your state to get a sales tax license, if your state has a sales tax. The disadvantage of this business form is your personal assets are not considered separate from your business assets. If you sell a product and the product injures someone due to a fault, the victim could sue the distributor of the product and they could sue you. Not only can your business assets be attached, but your personal assets as well. The advantage of this type of business structure is that you are allowed almost all of the business expenses and deductions that corporations can get. If you make a profit this money is added to any salary your received from your job or other income and is taxed at the normal rate. If you have losses, then you can often deduct these losses from your salary or other income.
An S-Corporation is the most common type of corporation used by small businesses in the United States. A S corporation does not pay taxes on its profits. All profits and losses flow through to the shareholders(you) and is considered ordinary income for tax purposes. Ordinary income is different from earned income in that you do not pay Social Security and Medicare taxes as well as federal income taxes. You only need to pay the basic federal income tax. An important advantage of incorporating is it limits your liability. Your personal assets cannot be attached and liquidated by creditors; only the corporation’s assets. In addition to limiting liability, an advantage of incorporating is credibility. When your business name ends with “Inc.” wholesalers will be more willing to deal with you, it is easier to get into trade shows and it is easier to find trade credit.
A partnership is formed when two or more people sign a partnership agreement and file taxes as a partnership. Partnerships have several disadvantages. If you or your partner are sued, then each of the partners is personally liable. If you and your partner decide to part ways, dissolving the partnership can become messy. A partnership does not enjoy all of the tax benefits nor is it as flexible as a corporation. And partnerships are considered a high value target for an IRS audit. Each partner is liable for a co-partner’s wrongdoing. An alternate form of partnership, the limited liability partnership (LLP), is formed when two or more people form an LLC (see below). The LLP enjoys most of the same benefits as the LLC, though each partner is often still responsible for the others’ wrongdoings.
A limited liability company enjoys some of the tax benefits of a sole proprietorship, as well as the liability protection of a corporation. There is no double taxation that can occur with a corporation. The liability is limited, in that the owners are protected from liability for certain acts and debts of the LLC, but may still be responsible for any debts beyond the fiscal capacity of the company.
Before any final decision is made about the type of business structure you choose for your business, consult a tax attorney or CPA. They can give you advice based on your individual needs as to what structure is best for your business, as well as additional ways to limit your liability and insure that you pay the least tax possible.