When you start a small business, it's essential to pick a structure for how you operate: sole proprietorship, partnership, limited liability company (LLC), C Corporation or S Corporation. Selecting a business structure affects your taxes, your liability risk and your ability to raise money from investors. So it's no small decision.

Gail Rosen, CPA, a small business tax specialist and a shareholder with Wilkin & Guttenplan, P.C., explains what you need to know about each entity to choose what's right for your business.

Sole Proprietorship

A sole proprietorship is the most basic business structure. "If you're the only owner of a business and you make a sale, guess what? You're a sole proprietorship." That's how the IRS sees you, in other words. Though you may need to apply for a separate tax ID number.

Taxes are simple for sole proprietorships, too: Your profit or loss goes straight to your personal income tax return. You don't need to file a separate business tax return and can potentially claim business losses as a personal tax deduction.

That said, a sole proprietorship doesn't provide any liability protection against lawsuits. While small businesses often start as sole proprietorships, Rosen recommends considering converting to LLC, C Corp or S Corp status. "The easiest conversion is to an LLC," she says, "since the LLC will not change the IRS reporting requirements."

Partnerships

Partnerships are like sole proprietorships but, naturally, with multiple owners. If a business with multiple owners starts making sales, it will be a partnership by default until the owners convert it to something else.

Owners of partnerships must apply for a separate tax ID for their business so they can file a partnership return with the IRS. This return lists how profits or losses are split between the owners. From there, profits or losses pass through to each owner's individual tax return according to the agreed split. Owners can potentially claim business losses as a personal tax deduction.

Another benefit of partnerships is that they're more flexible than corporations when it comes to dividing profits between owners. In corporations, owners must divide profits according to ownership shares in the company. These amounts can't change. If someone has 20 percent of the shares, they get 20 percent of the profits.

With a partnership, though, owners can make guaranteed payments to themselves out of the earnings, which can change year after year. This way they can adjust payments. If one partner did more work, for example, they can more easily get a higher percentage of the profits, too.

The downside of partnerships is that they don't offer liability protection. Once again, Rosen recommends considering converting to an LLC or corporation as soon as possible, noting again that an LLC is the easiest conversion since it does not change the tax reporting requirements.

Limited Liability Company

According to Rosen, there are many benefits to doing business as an LLC. LLCs offer liability protection, helping to guard an owner's personal assets from a lawsuit against the business. To be safe, LLC owners should still buy liability insurance.

LLCs also offer simple, pass-through taxation. This means that profits and losses pass through to the owner's personal tax return. "They're a hybrid entity which offers the best of both worlds," says Rosen. There's no limit to the number of owners for an LLC. You can be single-member if you're in business by yourself or multi-member if you have partners.

Finally, you can convert an LLC to a C Corp or S Corp later on. On the other hand, corporations cannot be easily converted into an LLC without potential tax issues. So starting with an LLC keeps your options open. Because of these benefits, Rosen finds LLCs to be the most common choice when clients are selecting a business structure.

C Corporation

C Corporations also offer liability protection against lawsuits. One of their main advantages over LLCs is that C Corps are more effective at raising money from outside investors. "If you want to bring on investors for your business, either now or in the future," Rosen says, "a C Corp may be the vehicle that investors prefer because it allows you to issue shares in exchange for capital."

Rosen also notes that sometimes small businesses become C Corps because a larger client has requested that they do so. "If someone is mainly working with one client as a contractor, the client could ask them to set up as a corporation. Otherwise, the client risks having to classify the small business owner as an employee."

However, C Corps do have some disadvantages. There is no pass-through taxation, which can trap losses in the business. If a business loses money, its owners will not be able to take the benefit of a personal tax deduction. They must claim the corporate loss against corporate income.

C Corps can also run into double taxation: Income is taxed at the corporate level and again when profits go to the owners. "Business owners might be able to sidestep this issue by paying themselves a salary," Rosen says, "but it is an extra concern, especially when the business is sold."

Finally, owners owe payroll taxes for unemployment and state disability when they do business as a corporation. These taxes don't apply for income from LLCs, sole proprietorships or partnerships.

S Corporation

S Corporations blend the features of an LLC and a C Corp. An S Corp permits pass-through taxation to shareholders' individual tax returns. As a result, S Corps can avoid the double taxation of the C Corp.

However, an S Corp limits the number of possible owners, has special rules governing who can be an owner and allows only one class of stock. So business owners should review with a small business tax specialist before embarking as an S Corp. According to Rosen, "S Corporations are not as popular as they used to be before the launch of LLCs."

Before selecting a business structure, Rosen recommends small business owners first meet with a CPA who specializes in business planning. As with all big decisions in life, careful planning can be a key element in securing a successful outcome.

Get more tips from our guidebook, "How to Start a Business."

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