Sole proprietorship or corporation? General partnership or limited partnership? Business expert Barbara Weltman offers her advice on choosing a business structure for your emerging small business.
When you start a business, you have to set it up in a particular way for legal and tax purposes. You have basically five choices. You can have a sole proprietorship, you can have a partnership, you can have a C corporation, an S corporation, or a limited liability company. There are some variations, but those are the five main options for you. The best person to give you advice on how to setup your business is an attorney who will help you work through the steps of doing it. Incorporating, for example, or forming a limited liability company, but it's always a good idea to run your proposed choice past a tax advisor. There are a number of factors that will impact which way you set up your business from a legal perspective. You want to think about personal liability protection. You want to think about how your choice will impact your income taxes. And of course, you also want to think about how your choice will impact your social security and Medicare taxes with respect to your profits. For many small businesses, the main choice of business entity is between an S corporation and a limited liability company, an LLC. They both offer personal liability protection. They both offer pass-through tax treatment. But there are distinctions between the two. For example, when it comes to an S corporation, there are some limits on the number and nature of shareholders. Also, there are some nuances when it comes to tax basis. This is important, because it may limit the amount of losses that you can take that get passed through to you from the business. And there’s one more important distinction between the two. And it’s the way social security and Medicare taxes get figured with respect to profits. There’s a difference when it comes to social security and Medicare taxes. For an S corporation owner, you only pay those taxes, FICA, on salary that you take from the business. But in a limited liability company, you pay those taxes through self-employment tax on your entire share of the profits. You do need to check state law and see how it will impact your decision on the type of entity that you have. As things change in your business, you may need or want to change your business entity. For example, you may start as a sole proprietor. But then, you’re bringing on employees. Your business is growing. Maybe at this point, you want to change your business entity to a corporation, a limited liability company. Or maybe you start out as an S corporation, so that the losses from the startup years can flow through to you. But then, you become more profitable and maybe you’re seeking venture capital, and maybe you want to terminate the S selection and be a regular corporation. So things can change.