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Me and My Business: The Two Don't Have to Be Inseparable
Choosing the right form of ownership can boost your income, cut taxes, and strengthen legal protection

Eagle Public Relations Inc. was Ed Emerman's sole proprietorship until April. He switched to a C corporation after his accountant noted this form of business ownership would give him several advantages, including the ability to deduct 100% of his health-insurance premiums on his taxes. "As a sole proprietor, the limit was 40%," notes the entrepreneur from Princeton, N.J.

It's an issue worth reexamining, because the form your company takes can have profound effects on how much you can extract in terms of salary and benefits for you and your family. What's more, in these litigious times, the old sole proprietorship and general partnerships may not provide enough legal protection. With a good lawyer, the customer from hell might be able to sue you not only for your entire business but your personal assets as well.

In recent years a new entity has been created to address some of these problems. The limited liability company has many of the advantages of a corporation, including protection of personal assets from lawsuits, but it retains much of the flexibility and economy of the sole proprietorship. "LLCs are the wave of the future," says Sander Ross, tax partner of Whitman Breed Abbott & Morgan, a law firm in Manhattan.

That doesn't mean all the old forms are obsolete. Picking the right one depends on your individual circumstances. Here's a quick guide to current forms of small-business ownership and how an LLC fits into the mix. Admittedly, converting from one to another can involve a great deal of paper-shuffling and no minor expense, but after reading this over, you may decide you'll come out ahead financially -- and in terms of how much sleep you get.

Sole Proprietorship
It doesn't get much simpler than this. You just do business and pay taxes on your regular 1099 form, albeit with the addition of Schedules C, for profits and losses, and SE, for self-employment tax. The upside: It's easy, and added expenses are almost nil in most states. (In some cases, you might want to set up a business bank account, secure a federal tax identification number, and register your trade name with your state.)

The downside: You pay both sides of the Social Security tax, the employer's as well as the employee's. You also have unlimited liability. If a business associate sues you, you could lose your home. You can buy insurance to protect you from most such perils, but, notes Cleveland attorney John Peca, "there's always the risk of a catastrophic type of liability, which would be in excess of any insurance."

General Partnership
For business and tax purposes, a general partnership is nothing other than a group of sole practitioners in business together. They might be lawyers or accountants, or the inside guy who makes the widget and the outside guy who knows how to sell it. Income and losses flow through to the owners; moneys aren't taxed on the business level.

There is no limit of personal liability in a general partnership, except for this: Under a doctrine called marshaling of assets, any claims against the entity must first be paid by the entity before the general partners are liable.

Limited Liability Companies
Created only a few years ago, the LLC has become ubiquitous, available in every state and often chosen by huge international enterprises like law and accounting firms, as well as small businesses.

For tax purposes, an LLC is a sole proprietorship, if it has a single owner, or a partnership, if it has many. For liability purposes, it is a corporation, with owners' assets protected from claims against the company. "The whole landscape changed when LLCs were recognized by the Internal Revenue Service," says Ross. "There's no additional layer of taxation and minimal complexity."

Corporations continue to have some advantages over LLCs in certain areas, such as providing deductible benefits. But Ross says choosing between the corporate and LLC form is the only smart choice for nearly all small businesses. The other forms leave you too exposed to liability.

C Corporation
Incorporating involves nontrivial expenses for a variety of things: separate accounting and taxation, including filing of quarterly tax-withholding payments; creation of a formal board of directors, which may have committees and outside members; designation of officers responsible for day-to-day operation (but not necessarily ownership) of the entity.

Why do it? Because corporations can provide fringe benefits to employees -- including the owners -- that might be disallowed on a Schedule C, such as health-club memberships and trips to Hawaii. The business's liabilities are, with exceptions intended to prevent fraud, insulated from the owner. The entity has a life of its own. It doesn't die with the founder.

The big negative is that corporate profits are subject to double taxes, first at the corporate level, and then at the personal level when they're paid to shareholders as dividends. In reality, small C corps are managed so as to not make a profit; yearend surpluses are paid as bonuses or otherwise distributed to shareholders.

S Corporation
For the most part, this type of corporation escapes double taxation and provides limits on personal liability. But it is also subject to a complex array of special rules that can make it cumbersome to operate. It can't have corporate shareholders, which rules out interlocking businesses, and foreigners also can't own stock. What's more, many states tax S corps as if they were C corps.

Still confused? Talk to a lawyer who specializes in small-business formation and to your accountant. When you do, don't forget about your company's future. If you're planning to be much, much bigger 10 years from now, make sure you choose an ownership form that will expand with you.

By Timothy Middleton in Short Hills, N.J.



A guide to diversification for small-business owners


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