You can conduct business in one of three legal
forms: a sole proprietorship, partnership, or
corporation; and in many states a fourth form -- the
limited liability company. Each has its charms and
drawbacks.
The sole proprietorship
As business setups go, this one is the simplest.
A sole proprietorship is a one-person concern that is
not closely regulated by state or federal governments.
All net income from the business counts as personal
income on your tax returns. Also, all liabilities of
the business are personal liabilities, so there are
risks.
This is a good way to start a business, since you
may be able to deduct your home office, transportation,
supplies, professional dues and publications, and many
other expenses. But you cannot deduct most employee
benefits, such as life and health insurance.
Partnership
This arrangement -- often consummated when someone
with an idea joins someone with capital -- is similar
to the sole proprietorship in that the owners are
personally liable for the activities and debts of the
business.
Profits are considered personal income for the
partners. When you take on a partner, you can be held
personally liable for any debts he takes on for the
company -- even if you don't approve them.
The corporation
You can incorporate even if you are the only
employee of the business. A corporation is a little
more costly than a partnership or proprietorship. It
must register with the state, pay an annual franchise
tax, file annual federal and state corporate tax
returns, and follow other procedures.
The corporation is a separate entity from you.
All transactions between you and the corporation must
be handled in a professional manner. You must strictly
document cash receipts and expenditures and handle all
personal transfers properly. When you're incorporated,
the IRS no longer considers you and the business to be
"one pocket," so there may be tax consequences to some
personal business transactions.
But the corporation still offers enormous
possibilities for income splitting, accumulating
earnings, and getting tax-free fringe benefits. (More
on these below.) And because the government treats you
and the corporation as separate entities, your personal
assets are usually protected from creditors and legal
settlements.
The limited liability company
A new form of business entity, combining the best
features of the corporation and the partnership, is now
available in many states. A limited liability company
has corporate limitation of liability, but the tax
transparency of a partnership. Formation costs are
usually similar to, or less than, corporate formation
costs. In some ways it acts like a Subchapter S
corporation, by passing through the tax advantages, but
it is more flexible than the Subchapter S corporation
because there are no restrictions on who may hold
shares in a limited liability company. It can have a
mixture of owners -- individuals, corporations, trusts,
non-resident aliens, non-profit foundations ...
whatever. Check with the corporation office in your
state to see if it is available in yet. Many states
have already provided for limited liability companies,
and enabling legislation is pending in many more.
