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One of the most fundamental decisions you make when getting your business off the ground is selecting its corporate structure, or what’s known as its corporate entity. Each of the five basic categories the law recognizes directly impacts the tax and legal liabilities of both an enterprise and its principals. Here are your choices:
SOLE PROPRIETORSHIP. A sole proprietorship is the easiest kind of business to form and manage. The owner runs the business in his or her own name and has full legal and financial responsibility.
Pros: You make all decisions, you receive 100% of the profits and it’s the easiest entity to dissolve.
Cons: Owners carry unlimited liability-whatever debts or legal encumbrances the business acquires are the owner’s full responsibility. The law considers a sole proprietor and his business one and the same.
“In this day and age, that’s a big risk for someone to take,” says Scott D. Smith, partner in the Washington, D.C., national tax practice department of KPMG Peat Marwick. He advises business owners to seriously consider their level of liability when opting for sole proprietorship.
GENERAL PARTNERSHIP. This form of partnership is composed of two or more individuals who invest and share in managing a company and agree to split the profits and liabilities.
Pros: A general partnership is relatively free of government restrictions-forming one is as simple as buying a partnership certificate at your local business supply store. Also, it allows profits and losses to pass through, before taxes, to your personal income and be taxed only once.
Cons: General partnerships also carry unlimited liability, which means all members of the partnership are collectively responsible for all of the company’s acts and debts.
LIMITED PARTNERSHIP (L.P.). If the pass-through benefit of a general partnership is appealing but sharing responsibility is not, consider a limited partnership. This is where a general partner teams with a partner with limited interest in the management of the business.
Pros: This business entity is best suited for a general partner looking for a silent partner(s) not involved in the day-to-day operation of the business (for example, an investor). The limited partner is not liable for debts and claims.
Cons: The general partner is liable for all debts and claims against the business.
S CORPORATION & LIMITED LIABILITY COMPANY (L.L.C.). According to Smith, many small companies are electing to adopt one of two business structures, a subchapter S corporation or a limited liability company, (L.L.C.). In some states, professionals such as lawyers, doctors and accountants can set up a limited liability partnership (L.L.P.).
An S corporation is limited to 75 shareholders, while an L.L.C. can have one or more shareholders (depending on the state), with no maximum.
Pros: Both protect principals from legal and financial liabilities and provide the pass-through tax benefit–income is generally taxed only once. L.L.C. registration is exploding, Smith says, because this entity also offers greater flexibility, such as less paperwork and fewer restrictions on shareholders.
Cons: In a number of states, an S corporation is subject to income taxes while an L.L.C. is generally not. Smith warns, however,