Which Business Entity is Right for You?

When deciding to start a business, the first of many decisions you'll need to make is exactly what form your business will take. Are you happy with a sole proprietorship, or do you plan to incorporate? And what exactly is a Limited Liability Company?

The usual choice for most small businesses is the sole proprietorship, as it offers many advantages and is one of the easiest business forms to understand. You control it, you gain all the profits from it, the paperwork is relatively light and you get to make all the decisions. Freedom is the biggest benefit with a sole proprietorship, whereas with most other business choices you have to give up a significant portion of control. You also have fewer restrictions from the government, so you don't feel as though you're being watched by the IRS all the time.

Unfortunately, along with the major advantages of a sole proprietorship come some pretty hefty disadvantages, largely in the liability sector. If someone sues your business for negligence or some other reason, both your business and your personal assets are at risk. You may also face a more difficult time raising capital as banks are less likely to take your venture seriously; you may face the possibility of using your own money or applying for a personal loan (based on your own credit history).

Like the sole proprietorship, a general partnership is also a relatively easy process. No costs or formalities are required, but it's generally recommended that you should have a detailed partnership agreement drafted whenever your name is on the same line as someone else's. Just a few of the issues that need to be addressed in the written agreement are the amount of capital each partner is expected to contribute before they start the business; what rights each partner is given; how profits and losses will be distributed; what methods will be employed for resolving disputes; and what to do should dissolving the partnership become necessary. It's an unfortunate but very real possibility for any partnership, no matter how close you are.

A limited partnership is similar to a general partnership except for one very important difference: the limited partner is protected by law because their legal liability in the business is usually limited to the amount of their investment. This method allows the investor to share in the partnership profits without the worry of being exposed to its debts if the company goes out of business. This protection covers the limited partner as long as they don't play an active role in the business' operation. If your partner prefers to be a "silent partner", this option may be the best choice for you.

If a sole proprietorship or partnership doesn't seem to be what you're looking for, you may want to start a corporation. Unlike the previous entities, a corporation is a created legal entity - separate and apart from the people who created and operate it. It only takes one person to form a corporation, which can be created by simply filing an application for a charter with your respective state. The information on the application will include the purpose of the business, the names of the incorporators, what capital stock the corporation will be allowed to issue, and the rights and privileges each type of stockholder.

Like the sole proprietorship, incorporating has its share of disadvantages. As the owner, you would be responsible for the bookkeeping and other administrative details. A corporation also has more tax issues to deal with, which can quickly overwhelm even the most stalwart individual.

The biggest incentive for taking on the added cost and stress involved with setting up a corporation stems from the realization that the shareholder is not held legally liable for the actions of the corporation. Other reasons include the unlimited lifespan of the corporation (not beholden to the lifespan of the individuals who run the company), the ability and increased ease of raising investment capital, and the ability of shares to be transferred to others.

More and more, the "limited liability company" entity is becoming a viable alternative to the above options. Many business owners have made the case that the LLC is ideal in situations where liability protection is going to be a real and primary concern, or where the company doesn't otherwise qualify for subchapter S status. It's an entity that has all the legal protection of a regular corporation, and the ability to be taxed like a partnership. As far as tax purposes are concerned LLCs are considered much like S corporations, but there are some additional advantages: an LLC offers better flexibility for owners who want to write off losses in a business depending on entity-related debt, and it gives greater flexibility to the owner to take resources out of the company without tax liability.

While it sounds like a no-brainer, you need to consult with a legal or tax specialist to find out how an LLC would work in your state. Any business whose primary function isn't in the insurance, financial or some professional service industry can become a LLC.