Starting A New Business

See Also 'Are You Ready for Entrepreneurship?'

One key decision when starting your business is choosing the form of business entity you will operate under. For starters, you can set up your business as a Sole Proprietorship, C-Corporation, S-Corporation, LLP (Limited Liability Partnership) or an LLC (Limited Liability Company). 

How do you decide which is best for your company? Small businesses typically decide against a C-Corporation, because C-Corps generate two levels of federal income tax. The C-Corporation pays one level of tax when it files its federal corporate tax return, Form 1120. A second layer of tax is imposed when the C-Corp's profits are distributed to the shareholders as dividends. Those dividends are reported and taxed on the individual's federal tax return, Form 1040. Together, these two levels of taxes are referred to as “double taxation.”

In addition, state taxes also typically apply to both C-Corporation profits and distributed dividends. Overall, the tax picture for C-Corps is far from ideal for small businesses. Even the current 15% tax rate on dividends does not completely do away with the disadvantages of double taxation. 

As a sole-proprietor you can avoid this double taxation. There are no corporate taxes to pay, and you only pay individual taxes on your net profits, typically reported on your Schedule C. However, you lack the legal protection that corporate status gives you. Simply stated, if you're a sole-proprietor, your personal assets are at risk if the business is sued! 

For years the S-Corporation was the standard choice for small businesses. S-Corp status provides a way for you to avoid the double taxation imposed upon C-Corps and their shareholders and you get the protection of limited liability. However, an S-Corp is more restrictive than an LLC.

Limited Liability Corporations, LLCs, started in 1977 and have quickly become a popular form of business entity for small businesses. LLCs with more than one owner (member) are taxed as Partnerships, while single-member LLCs are taxed as sole proprietorships. With an LLC you only pay taxes with your personal return. However, if you decide to do business as an LLC, you are not stuck with this status.

An LLC requires a bit more work to get started. Articles of Organization, to be filed with the state and an Operating Agreement (like a Partnership Agreement), LLCs offer more flexibility than S-Corporations. They can have an unlimited number of owners and any person, business or trust can be a member, or owner.  LLCs provide more ways to increase your tax cost basis. This illustrates a significant advantage of LLCs over S-Corporations. Because of the way these calculations are done, your cost basis may be higher for an investment in an LLC than if you set up shop as an S-Corporation.

The Bottom Line: Small businesses should probably start as an LLC. Advantages include flexibility of ownership, better tax basis, and pass-through of profits and losses. If a corporate entity is determined to be required later, the change from LLC to corporation is quick and tax-free.

These articles are in intended to be general guidelines and information to the public.  Be sure to consult with your tax professional regarding your specific situation.