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How should you set up your new business?

If you're forming a small business, you face several choices: One key decision is choosing the form of business entity you will operate under. For starters, you can set up your business as a Sole Proprietorship, Partnership, C-corporation, S-corporation, Limited Liability Partnership (LLC) or a Limited Liability Company (LLP). Lets explore the basic pros and cons you need to know.

How can you narrow that list down? Small businesses typically decide against a C-Corporation, because C-Corps generate two levels of federal income tax. The C-Corporation pays one level of tax when it files its federal corporate tax return, Form 1120. A second layer of tax is imposed when the C-Corporation's profits are distributed to the shareholders as dividends. Those dividends (when and if paid out) are reported and taxed on the individual's federal tax return, Form 1040. Together, these two levels of taxes are referred to as “double taxation.” In addition, state taxes also typically apply to both C-Corporation profits and distributed dividends. Pros do include, most importantly, the protection of personal assets as the Corporation is considered a “separate individual” capable of contracting it’s own debts, owning property, etc.. A corporation has flexibility in choosing a “fiscal” year vs. calendar year – this election is generally made the first year of operation. Other entities generally are required to have the same tax year as the owner(s), i.e. a calendar year – a “fiscal” year for non-corporates generally requires an explanation and approval by IRS. There are many types of “businesses” that should seriously consider incorporation for these and other reasons.

Doing business as a sole-proprietor eliminates the double taxation curse. There are no corporate taxes to pay, and you only pay individual taxes on your net profits, typically reported on Form 1040, Schedule C. However, as a sole proprietor, you lack the legal protection that corporate status gives you. Owners of corporations enjoy limited liability, but sole proprietors do not. Simply stated, if you're a sole-proprietor, your personal assets are at risk if the business is sued—very risky indeed!

That leaves LLCs, LLPs, and S-Corporations. LLPs and LLCs are similar in many ways. One key difference is that more than one individual must own LLPs. Remember, the “P” in LLP stands for partnership---by definition a single individual can't own a partnership. So if you had an LLP with two owners and one died, serious problems that might even cause the business to close could result.

The choice quickly narrows to an LLC or an S-Corporation. Which is more appropriate for your business?

Well, they are both “pass-through” entities that allow you to avoid double taxation, operating a business without paying corporate taxes. Net profits are reported by the owners in their individual tax returns. However, both also offer protection from unlimited liability. Your liability will be limited to your investment in either entity.

When choosing between an S-Corporation and an LLC you need to consider many things. What may be appropriate under one set of circumstances may not be in another. Every business is different, and every owner has different needs and expectations. Let’s review the attributes of each type of entity to help you decide.

The S Corporation
Created in 1958, the S Corporation was, for many years, the standard form of organization for conducting a small business. S Corporation status provides a way for you to avoid the double taxation imposed upon C Corporations and their shareholders. One advantage of the S Corporation is that income is taxed personally to the shareholders. However, your personal risk remains limited to your investment. In other words, double taxation is avoided and you get the protection of limited liability.

Your corporation chooses “S-Status” by filing a special election, Form 2553. Bear in mind that the “S” status of the Corporation only impacts taxes. Shareholders of S Corporations have all of the same legal protections as those in C Corporations. But as once said by a famous Tax Court judge, “a corporation is like a lobster pot. It's easy to get into…difficult to get out of.” In other words, once you have established an S Corporation, it would first have to be liquidated if you wanted to change to an LLC.

The Limited Liability Company (LLC)
LLCs started in 1977 in Wyoming and have quickly become a popular form of business entity across the country. By default, LLCs with more than one owner (member) are taxed as Partnerships, while single-member LLCs are taxed as sole proprietorships. As with S corporations, with an LLC you only pay taxes with your personal return. However, if you decide to do business as an LLC, you are not stuck with it. Through special arrangements, an LLC can be set up to become an S Corporation without having to liquidate. There is little risk of triggering a tax by changing from this form of doing business.

Setting Up Shop

Establishing an S corporation is relatively simple and inexpensive. An attorney, your tax practitioner or even you, can form a corporation by completing a series of “boilerplate” documents. These forms require you to complete the following information: who will own the business, the business's activity, address, and other miscellaneous details. Aside from being registered as an “Inc., Co. or Corp.”, a corporation can also be registered as P.C. (Professional Corporation). This designation is for professionals who choose to operate in corporate form and is popular with doctors, lawyers, and accountants.

An LLC requires a bit more work to get started. Articles of Organization, to be filed with the state and an Operating Agreement (like a Partnership Agreement), should be drafted by a lawyer. In addition, business information about the LLC must be placed in a published ad to give notice to the public that the company is being started. An LLC can choose to be registered as a P.L.L.C. (Professional Limited Liability Company) when its owners are licensed by the state to engage in a professional practice -- doctors, lawyers, accountants, and so forth.

Distinguishing Characteristics

An S Corporation might be more restrictive than an LLC. There can't be more than 75 shareholders in an S Corporation. In addition, only individuals, estates & qualifying trusts can qualify as shareholders. An S Corporation may not have any non-resident alien shareholders. There can only be one class of stock ownership. Adding a second category or class of ownership terminates the “S” Election, which could lead to unintended and unexpected tax consequences. The income and expenses