Forming a business is not quite as simple as just opening your doors and accepting customers, although if you choose to operate as a sole proprietor or general partnership it comes close. These businesses, in which the owners are the business, are the simplest to run, and owners pay taxes on their business income on their own tax return.

However, these business forms can also be risky, because the owners bear all financial and legal liability of the company. If someone sues the company, they are suing you, and you stand to lose your personal assets along with the business.

For this reason, many people prefer to set up a business that is a legal separate entity from its owners. Corporations and LLCs protect their owners from personal liability. Each form has advantages and disadvantages to consider.

Limited Liability Companies (LLCs)

The LLC is a relatively new type of business entity. It is generally the simplest way for a small business to operate and still protect its owners, who are called members. Business income and tax liabilities pass through to the members, who include their share on their personal tax returns. The business does not pay separate income taxes, which simplifies accounting.

On the other hand, because the LLC is its own entity, it is solely liable for debts. This is true even if the LLC has only one owner.

When forming an LLC, you file Articles of Organization. Managers, who are often also owners, oversee the day-to-day operation of the business, as set forth in an operating agreement. There are no shareholders, and no requirement to have directors or officers. The members make all decisions without outside interference or concerns.

You will generally pay a fee to the state for incorporation and then an annual renewal fee.

Corporations

A corporation is a legal entity with its own identity and existence that is treated as a person by the law. It pays its own taxes, enters into contracts as itself and can own property. Its owners are called shareholders and are not personally liable for any business debts.

The corporation pays taxes on its earnings before distributing dividends to shareholders. This often results in double taxation of corporation earnings, because shareholders pay income taxes on their dividends, even though the corporation already paid taxes on that same money.

Corporations are more complicated to form and run than are LLCs. They are subject to strict and complex securities laws. State and federal laws regulate:

  • Formation of a corporation
  • Issuing stock in a corporation
  • Accepting investors
  • Organizational structure, which usually includes having a board of directors, officers and shareholders

There are also often additional fees involved in forming and running a corporation. You may have to pay a franchise tax to your state simply for operating a corporation in that state, even if it has no taxable income.

On the other hand, corporations are often able to offer better employee benefits and deduct more business expenses than other business entities can.

Most corporations are C corporations that pay federal taxes under Subchapter C of the Internal Revenue Code. There is also a Subchapter S, which corporations can choose instead. In this case, income and expenses pass through to shareholders, just like members of an LLC or a general partnership, but there are a lot of special rules to forming an S corporation.

Financial Considerations in Forming a Business Entity

If you expect to solicit investors in your business, you will want to take that into consideration when choosing a business entity type. Most investors will not want to be part of a general partnership, since that will open them to too much liability. Even a limited partnership may be too risky if they are investing substantial sums of money.

If your investors will be members active in daily operations, then an LLC may be acceptable. On the other hand, if they expect fringe benefits or stock certificates, a corporation is probably best.

It's always a good idea to consult with a business lawyer to make sure you choose a business entity type that's right for you.