Intro:
Before you begin
Step 1:
Understand your options
Step 2:
Understand the advantages of incorporation
Step 3:
Understand the disadvantages of incorporation
Step 4:
Consider the S corporation
Step 5:
Understand LLCs
Step 6:
Understand sole proprietorships
Step 7:
Understand partnerships
Step 8:
Consider professional help

2torial #0907:
Learn2 Choose a Business Entity

Build your business on a firm foundation

Corporation? Sole proprietorship? Limited liability company? Even before your business is off the ground, you need to decide what its status will be--a decision that has huge legal and tax ramifications. And in a country with only 7 percent of the world's population and more than 90 percent of its lawyers, it's important to make the right choice.

Basically, it boils down to this: you need to decide whether or not to incorporate. By creating a corporation, you'll protect your personal assets from business debts and other liabilities as long as you follow certain requirements. On the other hand, you'll be subject to a whole new set of regulations that require a lot of paperwork. Your tax status will also change, which could save or cost you big money.

We'll explain how to untangle the rigamarole and pick the kind of business status that's best for your venture.

As you select a form for your business, remember you're not locked in forever. For the first couple of years, it may be simpler to remain a sole proprietorship, but as your company grows, the tax and liability advantages of incorporation may become worth the effort.

This 2torial provides a basic outline of the four major types of business entities: sole proprietorships, partnerships, corporations, and limited liability companies (LLCs). We can tell you some of the advantages and disadvantages of each, but there's no single formula that will tell you which is correct for your business.

Make sure you consult a professional (see Step 8) who can answer questions about your particular situation. He or she may also be able to propose hybrid business forms such as professional corporations, nonprofit corporations, limited partnerships, and professional limited liability partnerships, which may have special advantages for your business.

Understand your options

Before delving into the details, it's important to have a general understanding of the three basic forms a business can take. Here's the breakdown:

Corporation. The word "incorporate" has Latin roots, meaning "to create a separate body." That's basically what you do when you turn your business into a corporation. In the eyes of the state, a corporation is essentially a separate citizen with its own rights and responsibilities. A corporation can sue, borrow money, open bank accounts, and enter into contracts. It can also be sued and must pay taxes on its income. Because a corporation is a separate entity, it's responsible for its own debts and other liabilities. That means shareholders (people who own part of the business) can't lose more money than they've put in, even if the business owes much more, if certain requirements are met. Corporations can be privately held, with as few as one or two shareholders, or they can be publicly held, with open trading of shares and literally millions of shareholders.

S corporation and LLC. S corporations (a regular corporation with special tax status) and LLCs can be a profitable compromise for some businesses. They protect owners and investors from business debts and other liabilities, yet provide the tax breaks available to both corporations and sole proprietorships or partnerships. In many ways, these options provide the best of both worlds. However, not all businesses meet the strict rules these options impose and, like corporations, they must handle increased paperwork.

Sole proprietorship or partnership. Despite the benefits of incorporating, you may not want to do so. Instead, you can opt for sole proprietorship (if you're the only owner) or a partnership (if ownership is shared among two or more people). Such arrangements leave the sole proprietor or at least one partner personally liable for business debts and other liabilities. However, they also free you from paperwork and certain regulations. And since partnerships and sole proprietorships don't have to pay corporate income taxes, they may let you keep more of the money you earn.

Understand the advantages of incorporation

There's no single formula to decide if you should turn your business into a corporation. Instead, you must balance several factors. The following are potential advantages:

Protection from debts and other liabilities. As stated previously, incorporating can save investors big money if things go sour, since investors can only lose as much money as they put in. There are certain things, however, that can make investors personally liable if (among other things) bank accounts are co-mingled, proper corporate records aren't kept, or the corporation isn't funded sufficiently at the outset. Sole proprietors and general partners, on the other hand, are still responsible for the debts of their businesses, and their personal assets are vulnerable to seizure.

Added tax deductions. While partnerships and sole proprietorships can deduct certain business expenses from their taxable income, corporations have an even wider choice, including:

• Group health insurance plans
• Group life insurance up to a specified amount
• Certain transportation systems
• Employee education and training benefits
• Day care for workers with children
• Corporate meal plans
• Retirement plans

Raising capital. Corporations have an easier time raising capital by selling part ownership (stock), because investors are generally shielded from personal liability. This isn't always true for investors in partnerships (unless it's a limited partnership).

Longevity. Because a corporation is an entity in its own right, it can continue to operate smoothly even if a current investor dies (while the death of a partner or sole proprietor can essentially end the business unless there's a written agreement or more than one partner left in the partnership). If you want your business to outlive you, you might want to consider incorporation.

Understand the disadvantages of incorporation

Before you pay the costs to incorporate your business, it's important to understand some of the disadvantages (which could actually make other business structures, such as partnerships and sole proprietorships, more attractive):

Double taxation. Technically, corporations must pay taxes on profits. Then when after-tax profits are distributed as dividends to the owners, they (the stockholders) must declare this money as regular income and pay taxes again. Hence the phrase "double taxation." Double taxation isn't usually an issue for smaller, private corporations, who generally pay little or no corporate income taxes. Why? Because profits go directly into increased salaries or bonuses, thus avoiding corporate income taxes. However, double taxation is a concern for large, publicly held corporations who distribute profits to hundreds or thousands of shareholders.

Paperwork. Corporations are subject to strict rules about record keeping. If these rules are ignored, investors may lose their shield against personal liability. As a result, a corporation must expend more effort (and money) making sure it stays within the law. The fact that each state has its own set of regulations complicates matters, which means you should consult an attorney and a tax accountant.

Potential for decreased flexibility. Each corporation must have a board of directors. The board, which is usually elected by stockholders, has ultimate authority over the direction of the company, approving all major decisions. This may add a layer of bureaucracy to the management process that could make your company less able to respond quickly to a changing business environment.

Added costs. It costs money to incorporate your business. You'll also have to pay for added record keeping, and you may have to consult attorneys when you want to take any new or unusual action, just to make sure everything's legal.

Consider the S corporation

Created by the Tax Reform Act of 1986, S corporations are in many ways the best of all possible worlds. S corporations are taxed like individuals, yet shareholders benefit from the same liability protection as regular corporate shareholders. However, an S corporation must meet a strict set of criteria, including:

• A maximum of 75 shareholders
• Shareholders must be citizens or residents of the U.S.
• Only one class of stock (regular corporations can offer different classes of stock with varying prices and dividends)
• No more than 25 percent of the gross corporate income from passive income (in other words, they must create products and services, not simply produce investment income)

The S corporation is an excellent option if your company qualifies, but the strict rules can limit flexibility, especially for fast-growing companies that have the potential to become quite large. In addition, S corporations take on all the bookkeeping burdens of a regular corporation.

Understand LLCs

Like the S corporation, the LLC has many of the advantages of a regular corporation, but fewer of the disadvantages. Long popular in Europe and South America, LLCs didn't exist in the U.S. until Wyoming legalized them in 1977. Now they're an option in all 50 states plus the District of Columbia.

Like S corporations, LLCs generally shield investors from personal liability while avoiding double taxation. Unlike S corporations, LLCs can normally have foreign investors--a potentially big advantage. Plus their managerial structure is less restricted than a corporation's would be. Still, LLCs must conform to strict state and federal regulations, including:

• Limited life: many states require an LLC to dissolve after 30 years.
• No sole proprietors: many states require at least two shareholders.
• Increased paperwork: you'll have to fill out highly complicated paperwork to qualify for federal LLC tax status.

Understand sole proprietorships

If you're the sole investor in your business and you want full control with minimum paperwork, consider sole proprietorship. It could actually make you more profitable in the end. Many businesses start out as sole proprietorships, then incorporate as they begin to grow. Advantages of sole proprietorship include:

Convenience. You avoid all the cost and paperwork associated with starting and maintaining a corporation. You simply need to abide by local and state business regulations.

Control. You can make all decisions relating to your business without consulting partners or a board of directors. This provides increased flexibility, letting you make advantageous decisions on the spot.

Simpler tax structure. Income from a sole proprietorship counts as personal income, which means the business itself does not have to pay taxes. That removes a whole step from the taxation process, and could actually net you more money.

There are disadvantages, however, including:

Unlimited liability. You will be personally responsible for debts and other liabilities you incur in the course of doing business. If business assets do not cover the amount owed, you could lose personal assets, including your home. This is the single biggest reason to consider incorporation.

No checks or balances. A board of directors may seem like a hassle, but their expertise can be invaluable. As a sole proprietor, there's nobody around to catch your mistakes.

Trouble raising capital. Investors are more hesitant since they could end up personally responsible for business debts and other liabilities.

Fragility. If a sole proprietor dies or becomes incapacitated without a will or some other clearly written agreement, the business could cease to operate.

Understand partnerships

General partnerships are like sole proprietorships, except ownership and responsibility are shared among two or more people. A partnership has the disadvantage of unlimited liability for all the general partners, which can lead to the loss of personal assets and make large-scale capital raising difficult. On the other hand, partnerships avoid corporate paperwork, and profits are not subject to double taxation.

While at least one "general" partner must assume unlimited liability, it's possible to sign on "limited" partners. A limited partner cannot be liable for more than his or her original investment. However, the sale of a limited partnership interest is usually considered a "security," just like a share of stock, so certain security regulations must be addressed. This requires the expertise of a securities lawyer.

If you decide to work with partners, you generally have to forego some measure of control, as well as a share in the profits. This opens up the potential for conflict, so be clear how you'll divide investments, profits, potential liabilities, and decision-making powers.

In short, be sure you have a clear agreement that complies with the laws in your state, including a system to resolve potential disputes, before working with partners. A lawyer should be consulted for such an agreement. That said, partners can bring two essential ingredients to your business:

Capital. Partners can provide money to start or expand your business. Further, additional investors are generally more willing to jump aboard a partnership than a sole proprietorship, since risks and decision-making powers are often shared.

Expertise. Partners may know a part of your business even better than you. By combining talents and adding more input to the decision-making process, your business could be more successful than if you try to go it alone.

Consider professional help

If you have any doubts about which status your business should have, you should seek professional advice--especially if investment levels or potential profits are large. The process of registering your business is fairly simple. The real question is: what kind of business status should you seek? The following professionals can help:

Lawyers. Legal advice is invaluable along the road to running a successful business. Lawyers can help you draw up partnership and other investor agreements; ensure that you meet all requirements (particularly if you incorporate); understand any special liabilities your business may entail (so you can identify potential hazards); and understand how to register your business with state and local authorities.

Accountants. A good accountant can help you determine the tax consequences of the business entity you choose. In addition, an accountant may be able to advise you regarding the state in which you should set up your business. For example, Delaware and Nevada both offer special tax and fee breaks (and you don't even have to live or do business in these states to be registered there). On the other hand, such a move could actually increase your tax burden if you don't understand all the implications.

Incorporation specialists. Some companies specialize in shepherding new businesses by creating a corporation or LLC. They'll make sure the name you've chosen is still available, register your business, help you request the correct tax status, and handle the added paperwork if you decide to register your business in another state. Fees vary, but they're generally in the several hundred dollar range. You can find incorporation specialists on the Internet or in the yellow pages under "incorporating services."

Whether or not you seek professional help, take your time as you choose the right status for your business. The right decision could mean significantly more money in your pocket and, in some cases, much less red tape.

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