Incorporating a Small Business

This is the easiest form of business structure to set up, and is usually the most popular choice for single-owner startups. There is no cost and no special paperwork involved. The only records you are required to maintain are those you would normally keep for properly managing your business anyway. If you have inventory and/or depreciation issues to consider, you may want to have help at tax time.

Sole proprietorships also must pay self-employment tax, and when you begin to make a profit, you will likely have to make quarterly estimated tax deposits as well.

You should also be aware that state laws might differ, especially regarding financial obligations, so it is always best to consult your attorney when you are planning your business structure.

Because of the personal exposure, when your business takes off after startup, you will likely want to consider incorporating your small business.

Partnership

Each partner is responsible for their own taxes on the portion of profit they receive, and, like the sole proprietorship; they have to pay self-employment taxes. In addition, an “informational” tax form must be filed with the IRS every year, reporting how much money each partner earned from the "partnership" for the year.

Also, like the sole proprietorship, all of the general partners are personally liable for the debts and financial obligations of the business, as well as all of the actions of the business. The only exception to this is for “Limited Partners” who are only responsible up to the amount they have invested.

A Limited Partnership would normally be used where a partner contributes money, but is not involved in the day-to-day operation of the business.

The formation of a partnership can be relatively simple, or very complex (and costly) depending on the number of partners, and whether there are Limited Partners involved. By all means, it would be a good idea to work with your attorney when preparing these agreements.

Incorporation

The same holds true for the advertisements that encourage incorporation in a state with low incorporation costs, or low tax rates. Your attorney can spell out the reasons, but you will rarely save any money doing either of these things…and it could eventually cost you dearly.

Incorporating a small business differs from the sole proprietorship and partnership structures in that the business can become a tax-paying entity of its own. The corporation pays taxes directly on the profits it makes.

Regular corporations are called “C” corporations, named after that section of the IRS code that applies to them and the owners are only responsible for paying taxes on their wages or dividends received from the corporation.

Tax reporting is also much more complex for corporations and typically requires someone knowledgeable in corporate tax regulations to complete your annual corporate tax return—accurately.

One of the main considerations for incorporating a small business is to provide liability protection for the owner(s). The corporation takes responsibility for all debts and financial obligations it incurs, thus shielding the personal assets of the owner(s).

There may be ways around this in different states, so be sure to discuss this aspect of incorporation with your attorney. Of course, you also take on a whole family of "partners" in the form of a Board of Directors. This can be O.K., or not. It all depends...

One of the disadvantages of a regular C corporation comes when you sell your business—if you ever do—because the corporation must pay taxes on the gain in value of the corporation…at the normal income tax rate. Then, as the owner of the stock in the corporation, you must pay taxes on any gain you received from the sale of the corporation as well. This is the double taxation issue you frequently read about.

The primary way around this is to only sell your stock to the new buyer, and they then assume the operation of the business. This is often a tough sell for a small business, because the new buyer then exposes themselves to any unknown liabilities the corporation may have.

On the other hand, if you ever need to seek outside investors, you will need to be incorporated so you will have shares to provide to investors in exchange for their investment. Venture Capitalists will likely want your business to be a regular C corporation, but that depends on a number of things that you, your attorney, and the Venture Capitalist negotiate when the VC invests.

Preparing for an IPO is a whole different situation, and one that you do not need to consider at this time.

Subchapter S Corporation

A subchapter S corporation (sub S) passes profits through somewhat similar to a partnership, but without the liability exposure of a partnership. The regular C corporation is first set up, and then formal notice is sent to the IRS requesting that your corporation be allowed to elect the sub S designation, so all profits and losses are passed through to the owners.

There are certain restrictions on a sub S corporation, and there may be state regulations that affect this election as well, so, as with the other forms of business structure, you should consult your attorney before making any decisions.

Limited Liability Company (LLC)

Owners of an LLC are called members (LLCs do not have stock). Most states allow individuals, other LLCs, corporations, and foreign entities to be members. Most states also allow a single owner to setup an LLC and be the only “member.” This is often a good alternative to a sole proprietorship, where liability is a large concern.

There are also a few types of businesses that are not allowed to be LLCs, like insurance companies and banks.

It should be noted that a few states are attempting to set up a taxation program on the LLC entity itself, whereas the IRS allows federal taxes to pass through to the members. This situation could dampen the popularity of LLCs, so be sure to check with your attorney when you are setting up your business structure.

Other Forms of Incorporating a Small Business

• Qualified Joint Venture
• Non-profit Corporation
• Professional Limited Liability Company
• Limited Liability Partnership (LLP)
• Reverse Merger

So, now you have an overview of the various ways of incorporating a small business. The best form for you depends on what type of business you are starting, what form best fits your state laws and regulations, and what your attorney and other advisors are recommending.

After you have digested the information and decided on a legal structure for your business, I would suggest you go through the report on Business Startup Costs to get a better understanding of the cost of starting a business.