Should you incorporate?
Deciding what form your business takes affects liability and taxes
NEW YORK (CNNfn) -- Q: What's more important than picking out a name for your new small business?
A: Deciding how you'll organize your operation from a legal standpoint.
Broadly, businesses can take any one of three major forms -- a sole proprietorship, partnership or corporation. Each one has its own tax regulations and other consequences.
Here's a look at each of the three.
A sole proprietorship is a business venture carried on by one individual.
Sole proprietorships are popular with new entrepreneurs because such businesses require no Internal Revenue Service paperwork to start, unless the operation will have employees other than the owner.
The catch is that sole-proprietorship owners usually face unlimited legal liability if something goes wrong.
"Liability" refers to the extent a court can hold you responsible for your business' debts, or for any damages stemming from a lawsuit.
Because sole-proprietorship owners face unlimited liability, they can lose everything -- even personal property like homes -- if their company loses a lawsuit or defaults on a debt.
On the plus side, many experts feel that sole proprietorships enjoy better tax treatment.
Technically, sole proprietorships do not pay any income taxes at all.
Rather, the operation's owner report any business profits or losses as part of his or her own personal income taxes, using IRS Schedule C, "Profit or Loss from a Business (Sole Proprietorship)" and the Form 1040 personal income-tax return.
In some cases, sole proprietors must also pay self-employment tax and make estimated tax payments every three months to the IRS.
Partnerships are legal entities in which two or more people pool their resources and share any profits or losses.
In general, partnerships are something like sole proprietorships with more than one owner.
Like sole proprietorships, partnerships do not enjoy any liability protection, but also do not pay any income taxes.
Rather, individual partners list the operation's gains or losses on their Form 1040 personal income-tax returns.
A partnership must also file IRS Form 1065, "U.S. Partnership Return of Income."
Corporations are legal entities generally created by filling out articles of incorporation with your state government.
The word "corporation" derives from the word "corpus" -- Latin for "body" -- and federal and state laws often treat corporations almost like living entities.
Many businesses incorporate because their owners want to protect themselves from unlimited legal liability.
But on the down side, some feel the IRS taxes a corporation's profits twice.
First, a corporation must pay federal corporate income tax on any gross profits. Then, the corporation's shareholders pay personal income taxes on any profits distributed to them as dividends.
The IRS refers to a standard corporation as a "C" corporation. There are also two variants -- an "S" corporation and a "limited-liability" corporation (LLC).
"S" corporations and LLCs are sort of hybrids between sole proprietorships and "C" corporations. They enjoy "C" corporations' liability limits, but avoid the double-taxation issue.
However, "S" corporations and LLCs both have their own limits and regulations.
How to choose
Russell Orban, the U.S. Small Business Administration's assistant chief tax-policy counsel, says choosing one business form or another depends on "the liability you will be exposed to, the number of owners you have now or will have later, how you want the assets to be distributed, and what kind of growth plans you have for the future."
Orban said that if your main consideration involves protecting personal wealth like your home from liability, registering a business as a corporation could represent your best option.
But experts recommend that before you settle on any one option, do extensive research and planning, because changing from one business form to another can cost you plenty.
"If you decide down the road to change from, say, a 'C' corporation to an LLC, you'll probably have to liquidate your company and re-incorporate -- and pay a huge tax bill in the process," Jacksack said. "That's why we recommend that people think very carefully before deciding how to organize their business."