Forming Your Business

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.