The form of legal entity that is most appropriate for your business is one of the first decisions you will have to make. Should you incorporate the business? Should you operate it as a sole proprietorship? Unfortunately, the answer is often unclear. The right answer for each company depends upon the individual characteristics of the owners and the nature of the business. Some business owners may be interested in choosing the legal entity that will most simplify financial and income tax reporting; others may be most interested in limiting their personal liability for business debts.
Sole Proprietorship and Partnership
The sole proprietorship is a very popular form of legal entity for a new business because it is the easiest to set up, maintain and operate. One person runs the operation and reports all profits and losses personally (on Schedule C - Profit or Loss from a Business) on his or her individual income tax return.
A partnership is often chosen for the same reasons an individual chooses to be a sole proprietor. Both forms allow for flexibility in the distribution of assets while avoiding double taxation. In addition, partners can benefit by sharing the liability and capital responsibilities with one another; however, partnerships must file separate returns from the owners. Like the sole proprietor, the partners are personally liable for the debts of the business, a risk that often rules out the selection of these entities.
Limited Liability Company
The limited liability company (or LLC) is a relatively new form of entity that is gaining in popularity for many small businesses. The LLC is in many ways similar to the S-corporation. A properly organized LLC is taxed as a partnership and members are afforded limited liability from company debts. In addition, an LLC is afforded more flexibility than a C or S corporation in terms of raising capital, managing the business and distributing profits.
S-Corporation
The S-corporation ("The S") is a separate entity from the entrepreneur that combines the benefits of limited liability for shareholders of the C-corporation with the avoidance of double taxation of the partnership/sole proprietor. Like the partnership, the S must file a separate tax return, but does not pay tax on its profits. The shareholders of the S report the income on their individual income tax returns. The shareholder’s liability is typically limited to his or her investment in the corporation. As such, the S-corporation has been a favorite choice of many small businesses since its inception in 1987.
C-Corporation
A new business that is expected to experience tremendous short-term growth may benefit by electing the status of a C-corporation ("The C"). The C provides limited liability to its investors and places few restraints on the number of owners allowed. The C is classified as a "going concern", meaning that The C is expected to carry on business for an indefinite period of time. However, owners are subject to taxation both at the corporate level (when profits are made) and at the individual level (when profits are distributed).
