Here, small business experts break down the pros and cons of the four most common business types for new entrepreneurs.
Continue Reading Below
This is the simplest legal structure for solo business owners. You're not considered a separate entity in the eyes of the government.
It's cheap and easy. You can register the business in your county (making sure your name isn't already being used) and set up your company bank account — all in a day. And since many startups don't clear profits right away, you can declare the business losses on your personal tax return.
"The sole proprietorship gives you a chance to test your business concept without too much expense," says Tim Berry, co-author of "Three Weeks to Startup" and founder of Eugene, Ore.-based Palo Alto Software, a marketing and business plan software company.
Continue Reading Below
You also take on more personal risk because your business is part of your personal tax return.
"You're not a separate entity in terms of the Internal Revenue Service, so there's no corporate shield of being sued," says Berry, who also serves as an adjunct professor at the University of Oregon, where he teaches a course on how to start a business. In other words, you are personally liable for your business and any of its financial troubles.
If you're going into business with a partner, you might consider this structure. The IRS still does not consider your company a separate entity, although you'll have to submit an informational return detailing the profits and losses of the business along with your personal tax return.
You're still able to start your business in a relatively simple and inexpensive way. Plus, there are tax advantages to reporting your share of the partnership's profits and losses on your personal tax return.
All partners are still personally responsible for business debts. Your personal assets are also at risk even if it's just your partner's actions that get the business into trouble.
LIMITED LIABILITY COMPANY (LLC)
This is a popular structure for small businesses because it's adaptable and offers the liability feature of a corporation, without all the corporate formalities.
It's a flexible way to set up your business, and there's a shield against liability. (However, if you personally guarantee a loan for the business or run up personal credit cards, for example, you're stuck with the liability for those debts.)
"Many small businesses end up with a Limited Liability Company (LLC) instead of a corporation because they have the advantages of a corporation without the defined structure," Berry says. "The attorneys can write the LLC up in flexible ways. You can set up a limited liability company that mimics a corporation, or not."
You'll likely have to pay more upfront in attorney's fees.
"The LLC makes you much more dependent on the skill and expertise of your attorney," Berry says. "There's a lot more variation by state in the treatment of an LLC versus a corporation."
This structure will render your business a separate legal entity, offering greater protection from personal liability in the event of lawsuits and/or bankruptcy. Shareholders, on the other hand, stand to lose some-to-all of their investment in the unfortunate chance the company goes under. Along with shareholders, corporations are held accountable to a board of directors.
There are two variations of this business structure: the S-corporation (most common) and C-Corporation (mostly for high-profile ventures), according to Berry.
"A corporation cannot be a shareholder in an S-Corp, so if a business is looking to get venture capital fairly soon it will become a C-Corp instead," says Berry, noting that you can switch from S- to C-Corp relatively quickly, but the IRS makes you wait five years to change back from C- to S-Corp.
Again, there's greater liability protection, since a corporation is legally separate from its owners.
"The corporation can also have intellectual property, it can take loans and it's a lot stronger, cleaner way to operate when your company is separate from you," Berry says.
It's more expensive and there are more complex legal filings.
"A corporation has to pay more payroll taxes because the owners have to take a salary and pay unemployment and disability insurance on themselves, which you do not pay as an LLC," says Gail Rosen, a certified public accountant based in Martinsville, NJ. "You'll also pay more state taxes."
And once you establish a corporation, Rosen warns that you can't change your mind to simplify the structure. For example, if your business is suffering financial losses, you can't just switch back to an LLC, which can offer better tax advantages in that situation.
"Corporations can't go back to being an LLC, but you can always change later to become a corporation," Rosen says. "So if you want to keep it simple in the beginning, consider starting with an LLC."