Choosing a Business Structure Learn what to take into consideration when deciding among corporations, LLCs, sole proprietorships, partnerships and other structures.

This article has been excerpted from Ultimate Guide to Personal Finance for Entrepreneurs, available from Entrepreneur Press.

Many factors come into play as decision criteria for choosing an organizational structure: LLC, corporation, partnership, sole proprietorship or another variation. Some are straightforward and simple in terms of effects on your business and personal finances; others are subtler. There's no such thing as the "perfect" form for your business--oh, if only it were so simple. Your choice will be a balancing act among the various factors, advantages and disadvantages. To a large degree, it will reflect what you're most comfortable with, as well as the size and type of your business and your plans for the future.

It should be pointed out that most choices are not irrevocable. It's possible to migrate from one form to another as needs change.

The following are some of the major characteristics and criteria we will examine for each organizational structure.

Cash flow and tax considerations are the "600-pound gorilla" for many small businesses. Each organizational structure we will cover is taxed somewhat differently. The structure of your business can have significant personal tax consequences, depending on the nature of your business and your stage in the business life cycle.

Congress has tried over the years to mitigate some of these differences, so businesses don't choose the wrong form just for tax reasons. Congress also wanted to avoid creating loopholes. For that reason, for example, you'll discover that whether you pay self-employment taxes on all of your business income or pay half out of your corporation and half personally as FICA, you'll pay the same amount. You'll also find that if you decide to not pay yourself at all, as a corporation, you'll still pay a similar rate--15 percent--as a corporate income tax.

Yes, they have you one way or the other. Trying to avoid income or self-employment taxes altogether is a fool's errand, just as it's a myth that you can avoid estate taxes altogether by setting up trusts. But there are, as we'll see, some advantages to different structures depending on your situation. Here are a few with respect to taxation.

Tax structure and flexibility: The primary choice is between flow-through entities and a separately taxed entity--a corporation. In a flow-through entity, you are taxed on the net income of the business as if it occurred in your personal financial space; the business finances and your individual finances are treated as one for tax purposes. In that case you have less control over your taxes, for you can't keep earned income out of your personal statements once it gets through the gauntlet of business expenses related to producing that income. While those business expenses do give you some levers to pull, you'll end up paying taxes on what your business produces as accounting income, whether or not a dime of it finds its way into your personal checking account.

More flexible is the corporate form, specifically the C corporation, in which the business exists as a wholly separate legal entity. As such, it's taxed as a separate entity for all the income it generates. That income can be kept within the corporation as retained earnings; as such, none of it flows into your personal finances. The happy result: You pay no personal income taxes on this income.

Double taxation: But alas, we may not stay happy for long. When you finally pass some of that business income into your personal checking account, in the form of dividends (or wage compensation, if you work for the corporation you own), that income is taxable--for the second time. This is known as double taxation. If it's not managed well, the C corporation can clearly cost you more in taxes than would a flow-through business form. But if managed correctly, you can save in taxes and reinvest funds in the business that have been subjected to relatively lower tax rates.

While C corporations are subject to double taxation by the federal government, S corporations as flow-through entities are exempt, at least at the federal level. But at the state level--watch out. There are still some states that tax S corporation profits at the corporate level. Your tax professional will know.

Income splitting: With corporate forms, you can decide how to pay yourself and others in the business. You can pay yourself and your investors in the form of wage compensation, dividends, stock, stock options, or some combination of the above. Sharp-penciled entrepreneurs and their tax professionals navigate these choices with business and personal needs in mind; they can reduce the total taxes and the timing of those taxes at least to a degree. This is known as income splitting.

Treatment of losses: We've talked so far mainly about income--positive income--and the taxation of that income. What about negative income--losses? We talked about the relatively inflexible taxation of income with flow-through entities. While that's a negative for income, it can have a positive flip side in the case of losses. When you're in the investment phase, and even beyond, if your business produces a net operating loss, you can write off that amount against future income or current income generated from another source (like a job). While a flow-through entity isn't flexible in the sense that you can choose how much of this loss to take, it's nice to think that, in the initial stages of a business, you can organize in such a way as to capitalize on these losses, then evolve to another form later on.

Capital gains treatment: So far we've covered earned income--profits and earnings from business activity. But many businesses with fixed or investment assets also produce capital gains over time, as many have done in recent years from real estate holdings, for example. We know that personal long-term capital gains--for assets held for more than one year--are taxed at preferential rates for individuals. As such, they are taxed preferentially for flow-through entities, for the individual is the entity.

On the other hand, the corporate form does not generally recognize separate tax rates. So businesses with considerable capital gains may be set up as C corporations for other reasons but then, using one popular strategy, hold real estate assets personally or in some other entity, lease them out to the business, and pay taxes on them personally.

Peter Sander is an entrepreneur, columnist and author of 15 books focusing on personal finance and business topics. J. Jeffrey Lambert, CFP, is an award-winning certified financial planner and partner of Lighthouse Financial Planning in Sacramento, California. They are co-authors of Ultimate Guide to Personal Finance for Entrepreneurs, now available from Entrepreneur Press.

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