Tips for choosing the right ownership structure

When you start a business, you must choose an ownership structure for it. For example, 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. Some of the most important factors involved in picking the right legal structure for your business are:

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.
Your investment needs.

Risks and liabilities

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 a limited liability company (LLC).

Formalities and expenses

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 almost always more expensive to create and more difficult to maintain. To form an LLC or corporation, you must file a document with the state and pay a fee, which ranges from about $40 to $800, depending on the state where you form your business. 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.

Business owners who are starting out on a shoestring often care most about spending as little money as possible on the legal structure of their business. For them, it can make the most sense to form the simplest type of business — a sole proprietorship (for one-owner businesses) or a partnership (for businesses with more than one owner). Unless yours will be a particularly risky business, the limited personal liability provided by an LLC or a corporation may not be worth the cost and paperwork involved with creating and running one.

Income taxes

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 the first $75,000 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.

Investment needs

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 public capital by making a public 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 a corporation probably isn't worth the added expense. If it's limited liability that you want, an LLC provides the same protection as does a corporation, but the simplicity and flexibility offered by LLCs offer a clear advantage over corporations.

Getting expert help

After learning the basics of each business structure and considering the factors discussed above, you may find that you need help deciding which structure is best for your business. “Kolita & Company” or a good small business lawyer can help you choose the right one, given your tax picture and the possible risks of your particular situation. You might also benefit from reading "Choosing a Legal Structure for Your Small Business" by Fred S. Steingold (Nolo).

Changing your mind

Keep in mind that your initial choice of a business structure isn't necessarily permanent. You can start out as sole proprietorship or partnership and later, if your business grows or the risk of personal liability increases, you can convert your business to an LLC or a corporation.