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Clients beginning new businesses often ask "Should I incorporate?"  To answer this question, it's necessary to analyze two aspects of the decision, the tax and the non-tax aspects.  I'm not going to get into a complete discussion of the tax aspects here, but will briefly discuss the most important non-tax aspect - limited liability.  If you conduct business through an entity which features limited liability, creditors of the business can only look to the assets inside the business as a source for payment of business debts.  The personal assets of the owner are not up for grabs.  There are exceptions to this general rule such as claims arising from professional negligence, and business debts which have been personally guaranteed by the business owner.

In my opinion, most businesses should choose an entity which features limited liability although this does not necessarily mean a corporation.  With the prevalence of litigation today and the widely-held belief that all unfortunate occurrences should be compensated, it is just too dangerous to conduct business with unlimited personal liability.

Now for a brief explanation of the various entity choices available today.

Proprietorship:
This is the "default" entity for a single-owner business.  In other words, if you do nothing to select another entity, this is how the IRS will classify your business.  Features of proprietorships include:

• Simplicity - no separate tax returns to file, business income is included on owner's tax return

• Unlimited liability - business and owner are the same so owner's assets are subject to creditor claims

• Tax on business income -  paid by owner on personal income tax return

Partnership:
This is the default entity for a business owned by two or more owners.  Business income is determined annually and reported on a partnership income tax return.  The partners report their share of the business income on their personal tax returns.  Liability is UNLIMITED.  All partners are liable for business debts which can include liabilities arising from the actions of other partners.  (A scary way to conduct business!)  General partnerships are mostly used for common ownership of investments where potential liability is not an issue.  For example, stock investment clubs. 

C Corporation:
There are two types of corporations widely used to own businesses, C corporations and S corporations.  Both require filing various forms with the appropriate state agency to be legally formed.  Corporations are separate legal entities, the business is separate and distinct from the people that own it. 

After you have legally formed a corporation, it will be taxed as a C corporation unless you file an election to be an S corporation.  A C corporation determines its net income on an annual basis and pays income tax with its available funds.  It has its own tax rate schedule which has progressively higher rates as income increases.  Certain personal service corporations do not receive the benefit of progressive tax rates, all their income is taxed at the highest corporate tax rate, currently 35% for federal tax.

One of the principal disadvantages of the C corporation is double taxation.  If the owner wants to withdraw corporate cash remaining after payment of business expenses and corporation income taxes, it's called a dividend and taxed again on the owner's personal income tax return.

C corporations are generally more advantageous than partnerships, S corporations and limited liability companies for providing tax-free employee benefits such as health insurance to owner-employees. However, this advantage is being phased out over time by recent law changes. 

S Corporation:
An S corporation is a corporation in every respect.  The main difference is that it is taxed more like a partnership (See Partnership above).    Like a partnership, an S corporation prepares an annual tax return but does not pay the tax. S corporation net income is reported on the personal  tax returns of the owner(s) in proportion to stock ownership.  To become an S corporation, an election form must be filed with the IRS requesting permission to be taxed as an S corporation.  The election must be filed within 2-1/2 months from the beginning of the tax year and is usually automatically granted if the corporation meets the requirements.

S corporations avoid the problem of double taxation that plague C corporations. The shareholders of an S corp. can take cash out of the corporation as dividends without any negative tax consequences since they already paid income tax on the funds.  S corporations are often used for new businesses expected to generate losses in the first few years because the losses can be used to offset the owners other sources of taxable income. 

Tax savings in self-employment taxes can be achieved through the use of S
corporations.  The employee-shareholders in S corporations take some
funds out of the corporation as a salary and some funds as dividends.  Salary is subject to FICA/Medicare tax but dividends are not.  You should seek professional assistance in this area.   

Limited Liability Companies (LLC):
An LLC is a partnership for tax purposes (See Partnership above) with limited liability protection for its owners.  It combines the relative simplicity (is anything connected with taxes simple?) of partnerships with the corporate benefit of limited liability.  Also, most states allow single member LLC's so unlike a partnership which must have two or more owners, an LLC can have only one owner.  A single member LLC is treated like a proprietorship for income tax purposes, but has limited liability with respect to business debts. 

LLC's allow a lot of flexibility in allocating the company income to the owners. Additionally, there are less restrictions on who can own shares of an LLC as compared to S corporations.   LLC's are often used to own real property and service businesses.

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