Small Business Taxes & Management^TM--Copyright 2016, A/N Group, Inc.

Everyone thinks the first step to starting a business is incorporating or organizing an LLC (limited liability company). While both types of entities can provide your business with additional protection, they're not the answer for everyone. And that protection comes at a cost. We've created a list of some factors that should be reviewed before deciding on an LLC or corporation or a sole proprietorship. We've assumed that your business, at least in the beginning is a one-man show--no partners and no employees. While that leaves out many startups, it encompasses many more.

Points to Consider

Potential liability. If you're designing and importing a children's toys, you need all the protection you can get. On the other hand, if you're a carpenter your insurance should be able to handle most liability issues. Many professionals are likely to be sued personally even if the business is incorporated. Things quickly change if you have employees. If that's the case a corporation or LLC can protect you personally.

Business debts. In earlier times the corporate form was used mostly to protect owners from being personally liable for corporate debts. Today, it's used for personal protection from a range of lawsuits. But for most small businesses, owners will be required to guarantee any bank, etc. loans. The only advantage to a corporation or LLC may be avoiding accounts payable on a default. And even a corporation or LLC won't protect you if don't respect the formalities of the entity.

Cost. If you do it yourself, the cost of setting up (and dissolving if it doesn't work out) a corporation or LLC may be relatively small (generally between $125 and $800). Using an attorney will add to the cost. There may be annual fees such as filing fees and franchise taxes. These vary widely. Not much of an issue if the business is nicely profitable, but a burden if you're suffering losses. If you do business as a corporation (S or C) you'll have a separate return to file. A consideration if you have a professional prepare it.

LLC vs. S corporation. While you could do business as a regular (C) corporation, you could find yourself subject to double taxes. Most small businesses elect S corporation status where profits and losses are passed through to the shareholders. An LLC with only one member is a separate entity for legal purposes, but is disregarded for federal tax purposes. That is, instead of filing a partnership return (the normal return for an LLC with more than one member (owner)), a single-member LLC reports its income and expenses on the owner's Schedule C. That, plus the fact no balance sheet is required, can save some preparation costs at tax time.

DBA. If you're doing business as a corporation or LLC you decide on a name when filing with the state. While you could use your own name (e.g., Fred Flood, Inc.) that's usually not the case. As a sole proprietorship, the default is to use your own name. That's fine if you're Fred Flood, CPA, but not so attractive if you want to brand the business. The solution is filing with your state for a DBA (doing business as) to do business under an assumed name (e.g., Fred Flood doing business as Madison Auto Body). You have to decide if you want the extra work of a DBA.

Transactions between you and entity. If you're doing business as a separate entity, you've got to respect the formalities. Business assets are purchased and titled in the name of the entity. Assets transferred to shareholders or LLC members should be accounted for on the books and for tax purposes. Loans are taken out in the name of the entity. Not in your name personally. Paying a corporate loan (or other expense) with a personal check won't get you a deduction. The proper approach is either to make a loan or equity contribution to the business so the business can pay the expense and get the deduction. Alternatively you can submit an expense report and have the business reimburse you. Paying personal expenses with a business check as well as not respecting other formalities such as making customers, creditors, etc. aware that you're doing business as an LLC or corporation can allow outsiders to challenge the existence of the corporation or LLC. It sounds simple enough, but most small business owners don't follow through. A sole proprietorship doesn't have these problems.

Switching entities. If you start a business as a sole proprietorship and later decide to incorporate or change to an LLC, doing so is relatively straightforward and there are generally no tax consequences. Going in the other direction can be more complicated, particularly if you have fixed assets. In some cases there may be tax consequences.

Best approach? If you have or will have shortly, owners in addition to yourself, you might as well use a corporation or LLC from inception. If additional owners are unlikely (at least for some time) a sole proprietorship should be considered if the liability protection of an LLC or corporation isn't needed. You should discuss the issue first with your attorney and then with your tax advisor.

--Last Update 07/22/16