Starting a Business? Don't Skip This Key Step

Steve Marks of Marks Lumber was the Small Business Administration's 2011 Small Business Person of the Year. Source: SBA.

Starting a business appeals to the inner entrepreneur in all of us. Whether you're fed up with your boss or can't find the job you want, starting a business of your own can be incredibly rewarding, and the legal structure in the U.S. makes it easier to embark on the entrepreneurial path than many other countries do.

One of the key decisions many new business owners don't give enough thought to is what type of business entity they should use. Among the most popular are sole proprietorships, partnerships, corporations, and limited liability companies. Below, we'll take a look at all of these types of businesses to help you decide which one best fits your situation.

Sole proprietorships
A sole proprietorship is the simplest way of starting a business, and it's also the most common. In fact, if you go into business on your own and don't do anything else, you'll automatically be treated as a sole proprietorship.

Sole proprietorships give you complete control of your business and cost relatively little to set up. For tax purposes, you include the income and expenses of your business on your personal tax return, with no separate business return necessary. But the downside of a sole proprietorship is that if your business fails, your own personal assets are at risk, as creditors can go directly after your non-business property with no legal protection for you.

The Small Business Administration helps many new businesses. Source: SBA.

Partnerships
Partnerships are also fairly easy to form, being the default business entity when there are two or more owners involved. Although legally creating a partnership is as simple as going into business together, smart business owners write up partnership agreements that carefully set out who's responsible for what and how they will split up the costs and profits of their business.

Partnerships allow almost unlimited flexibility in starting a business. They're usually not subject to tax at the partnership level, although preparing a partnership tax return is necessary to apportion taxable income and expenses out to the partners. Unfortunately, like sole proprietorships, most partnerships don't have any legal protection from liability, meaning that creditors can come after the personal assets of the partners to satisfy partnership obligations. Even worse, each partner is potentially liable for the entire debt of the partnership -- not merely that partner's proportional share in the partnership.

Corporations
Corporations involve a lot more paperwork and fuss than sole proprietorships or partnerships. But they also address the liability question that partnerships and sole proprietorships don't, making them appealing as business entities.

Starting a corporation requires filing with the state and following numerous formalities, including naming members of a board of directors and officers of the business. The business has to remain separate from the individual finances of the owners, meaning you'll have to have a business bank account and separate accounting that only includes business-related activities.

Smart planning and SBA loans helped protect the assets of restaurateur Constantine Stavropoulos from personal liability. Source: SBA.

The payoff of a corporation is that if your business fails or faces legal liability, only its assets are at risk. The personal assets of the shareholders of the corporation aren't subject to attack from creditors, so long as the business owners respect the formalities of having a corporation. If you skip those formalities, you open yourself to legal arguments that you aren't running the business as a corporation and therefore don't deserve protection from claims.

Taxes for corporations are also more complex. For ordinary corporations, a separate tax return imposes tax at the corporate level, and shareholders then have to pay additional taxes on dividends they receive. In some cases, though, small businesses can elect treatment as what's called an S corporation, which more closely resembles how partnerships get taxed.

Limited liability companies
Limited liability companies combine the best aspects of partnerships and corporations. As with corporations, members of an LLC enjoy protection from liability for their personal assets. But like partnerships, LLCs don't generally get taxed at the entity level, instead following the same procedure that partnerships use to pass through their income and expenses to their shareholders.

LLCs do have more formalities than partnerships, requiring registration with your state. But the benefits have made LLCs wildly popular in recent decades, supplanting corporations for those in high-risk occupations.

Be smart about your business
Your choice of business entity makes a huge difference in the risk involved in starting a business, as well as the potential rewards. By taking time up front to consider the best type of business for you, you'll be in a better position to focus all of your efforts on being successful in your new venture.