What Type of Business or Company Should I Form?

When you're first considering starting a business, your options can be overwhelming. If you're new to the whole business thing, you're probably asking around for advice as to which type of business you should form.

Business owners might have a strong opinion based on what has worked well for them in the past—but the fact is, their situations are not your situation. With so many business options out there, each with their own set of pros and cons, it's important for you to have a handle on the basic characteristics of each type of business so that you can decide on the one that best meets your unique needs.

With that, let's take a look at an overview of four of the most common types of businesses: sole proprietorship, partnership, LLC, and corporation.

The simplest type of business, a sole proprietorship DBA consists of on person—the sole proprietor—doing business as a name that is not his or her legal name.

Pros:

• A sole proprietorship is simple to set up, and simple to dissolve.

The filing is typically done with either the Secretary of State's office or the County Clerk, and filing fees from state to state can range from $5 to $120.

• Sole proprietorships typically do not require a great deal of startup capital; filing fees are relatively cheap compared to incorporated businesses.

Many single-owner small businesses begin as a sole proprietorship because of the low investment.

• There are less tax responsibilities associated with sole proprietorships than the incorporated entities.

Incorporated businesses have to file annual reports and other periodic filings; typically, sole proprietorships do not have these requirements.

Cons:

• Sole proprietorships don't last forever.

If the owner of a sole proprietor dies, there's no procedure for passing the business on to anyone else; since the sole proprietorship and the individual owner are, essentially, the same entity, when the owner terminates, the business is terminated.

• Sole proprietorships do not offer any personal liability protection.

If the business defaults on a loan, the courts can seize the owner's assets.

• Renewal filings are required in order for the business to continue to exist.

Many sole proprietorships are good for a set period of time, typically 5 or 10 years; at the end of that period, if the business has not renewed its filing, it ceases to exist.

A partnership DBA (called a general partnership) has many of the same characteristics as a sole proprietorship, with the obvious exception that there are more than one individuals involved.

General partnerships share most of the same pros and cons as a sole proprietorship, with a few additions:

Pros:

• With a partnership, there are more people to bounce ideas off of and share the workload.

Being a sole proprietor can be overwhelming, and partnerships offer business owners a way to enjoy this structure while giving each other support.

Cons:

• Not only is there no personal liability protection—but both partners are equally liable for the business.

If one partner makes a poor business decision, and the business ends up in the tubes, both partners are responsible for the ramifications.

An LLC, or Limited Liability Company, is a type of incorporated entity, meaning that the business is a legally separate entity from the owners.

Pros:

• LLCs, not surprisingly, provide limited liability to the individual owners.

If an LLC defaults on a loan, and the owners have followed all of the corporate formalities, their assets are safe.

• LLCs are pass-through entities.

Rather than being taxed at the corporate level and then taxed again at the individual level, LLC profits are passed through directly to the individuals and reported on their tax returns.

• The ownership structure of an LLC is very flexible.

There's no limit to the amount of owners an LLC can have.

• Owners can distribute profits however they like.

In the LLC Operating Agreement (the governing document, which all owners will agree on and formally adopt), profit distribution procedures will be laid out—regardless of the percentage of startup capital each owner invested in the company. (This makes an LLC a perfect structure for a company in which one owner has contributed the majority of the startup capital but is not as involved in the day-to-day business, whereas the minority contributor runs the business and takes a higher percentage of profits accordingly.)

Cons:

• LLCs pay a self-employment tax.

Depending on the tax structure the company elects with the IRS, an LLC will pay a 15.3% federal tax.

A corporation—the type of business with which we're all probably most familiar with because of the "Inc." ending frequently seen at the end of business names—is a type of incorporated entity. For-profit corporations are divided into two classes: S corporations and C corporations. Both provide limited liability to owners and both allow for a deduction of health insurance premiums, but that's where the similarities end.

C Corporation

Pros:

• A C corporation has a more flexible ownership structure.

Individuals of any kind (US citizens or non-citizens) can act as shareholders. Additionally, existing business entities can also buy shares of stock in a C corporation.

• C corporations can have more than one class of stock.

Cons:

• Possibly the most notorious drawback to a C corporation is something called "double taxation."

With double taxation, a corporate tax is applied to the corporate income. Then, when it is distributed to the owners of the corporation, it is taxed again.

S Corporation

Pros:

• An S corporation is a pass-through entity.

Just as with an LLC, an S corporation avoids the corporate tax of a C corporation by taxing profits only as they are passed to the individual owners.

• S corporations provide limited liability.

As with the rest of the incorporated entities, if an S corporation defaults on a loan or goes severely into debt, this does not affect the assets of the individual owners.

Cons:

• There are more stringent ownership limitations in an S corporation than in the other incorporated entities.

S corporations cannot have more than 100 owners, all of whom must be individuals (not business entities themselves) and must be US citizens or resident aliens.