Business planning: Choosing a legal structure

Right out of the gate, you'll have to determine what structure your company will take for tax and legal purposes. The common forms are a corporation, a sole proprietorship or a partnership. Laws vary significantly from state to state so be sure to contact the state office that handles business services -- usually the office of the secretary of state -- before filing for these structures.

How you decide to form your business will depend in large part on:

• The type of business you have
• Tax advantages
• Potential liabilities
• Your level of income or earnings

The IRS gives entrepreneurs the choice of five types of business entities:

Sole Proprietorship
This low-maintenance business structure puts up few legal hurdles and costs almost nothing to establish. More than 75 percent of all businesses are sole proprietorships, according to the Service Corps of Retired Executives. But the structure offers no protection from liability, and that makes it difficult to raise money.

As a sole proprietor you have absolute authority over the business and you own all the assets. If the company makes a profit, it's yours. Of course, if the company incurs a debt, so do you. One way to create balance in the work and debt load is to form a partnership.

Proprietorships usually have to pay local licensing fees and may need to file a business name statement.

Partnerships
Commonly used by doctors and lawyers, partnerships offer no liability protection. In fact, each partner not only has to guarantee liabilities but is also responsible for any partner's negligence. Profits and losses are divided among partners.

There are two kinds of partnerships, general and limited. In a general partnership, the partners share equally, for better or worse. A limited partnership consists of at least one general partner and one limited partner. The general partner has greater control in some areas of the business. The limited partner is limited by the amount of his investment.

Partnerships may need to pay for attorney services to draw up agreements, and usually file with the state for recognition as a business entity.

Corporations
The corporate structure offers the owners, called shareholders, a way to separate themselves legally from the business. The shareholders own the corporation and the corporation owns the business assets, so personal liability is limited.

For the owner of a small, part-time business, incorporation is probably more trouble than it's worth. But if the business has any employees and the company makes more than $8,000 a year, forming a corporation would provide a benefit due to tax structuring.

Here's why. Sole proprietors pay a 15.3 percent self-employment tax on income. An S Corporation -- a common corporate entity for small business -- doles out money in two forms: wages and profit distributions. Profit distributions are exempt from the 15.3 percent self-employment tax. So an S Corporation saves $1,530 for every $10,000 profit distribution. If the S Corporation brought in $8,000, the entrepreneur might pay himself $6,000 in wages and call the other $2,000 a profit distribution. Therefore, the entrepreneur wouldn't have to pay the Internal Revenue Service 15.3 percent of that $2,000, or $306, which is about equal to the cost of incorporating.

Corporations usually pay attorneys to draw up incorporation papers, which are then filed with the state. They are required to appoint an agent who lives in the state to accept any documents being served on the corporation. There are two basic types of corporations, the S Corporation and the C Corporation.

• S Corporations -- The Service Corps of Retired Executives says this structure is most appropriate for startups. It limits liability while sheltering some of the self-employment taxes paid by sole proprietors. The S Corporation limits the number of shareholders in the company to 75, and allows for only one class of stock.
• C Corporations -- So known because they are taxed under regular corporate income tax rules, C Corporations also offer liability protection. But unlike other business structures, the C Corporation's income is taxed twice. The corporate income is taxed, and the dividends paid to stockholders are subject to personal income tax.

And then there is the Limited Liability Company. The LLC is a hybrid structure. It combines the tax advantages of a partnership and the liability protection of a corporation. Owners are called members and the company can issue both voting and non-voting stock.