Starting Out: Keep It Simple

If you're starting a new business by yourself (married couples count as one owner), I usually tell people to start as a sole proprietorship. You'll still want to talk to a lawyer about whether you need extra liability protection, but either way, make sure you get good insurance coverage - that's non-negotiable no matter what type of business you set up.

Here's the thing though: when you need to borrow money or lease space, banks and landlords are going to make you personally guarantee those debts anyway, so forming a corporation or LLC won't really let you walk away from big business debts.

When It Makes Sense to Level Up

That said, there are good reasons to move beyond a simple sole proprietorship and set up a corporation or LLC. Picking the right business structure means weighing the pros and cons of each option - both the tax stuff and everything else. Here are some common situations that'll help point you in the right direction:

When You Have Business Partners

If more than one person owns the business, you absolutely need a written agreement that spells everything out. This isn't optional. You need to figure out:

• How will you split the profits and expenses?

• Will the owners take salaries? If so, who decides how much?

• What happens if someone dies or can't work anymore?

• What if one person needs health insurance but the other doesn't?

• What if one owner wants to put money into a retirement plan but the other doesn't?

• What if the business needs more cash?

You need answers to these questions before you even open your doors, not after problems come up. Get a good business lawyer to help you write this agreement when you're setting up your partnership, corporation, or LLC. Also, keep in mind that corporations have way more paperwork requirements than LLCs, which can be a real headache if you have minority shareholders.

When You Need Flexibility with Money

Let's say two people start a business together, but one person puts in more money or equipment than the other. Maybe you want to split profits unevenly or let the person who brought the equipment claim the depreciation on it. You can make special arrangements like this with partnerships and LLCs, but S corporations really don't like it. With S corporations, all shareholders must have exactly the same rights when it comes to getting money out of the business.

Saving on Payroll Taxes

With S corporations, owners pay payroll taxes plus income taxes on their salaries, but only income taxes on any leftover profit. But check out my separate page that compares S corporations and LLCs for more details.

Liability for What Your Partners Do

In a general partnership, you could be on the hook personally for what your partners do. That's something to think about.

Planning for the Future: Going Public or Selling

If you think you might eventually make your company public or sell it to investors, a C corporation is probably your best bet. Investors know how C corporations work, and there are some nice tax breaks when you sell qualifying corporate stock.

If selling is in your future vision, talk to an experienced tax accountant to make sure your stock will qualify for those special tax breaks. Just be aware that C corporations can get hit with double taxation when you shut them down.

Heads up: Recent tax law changes have made C corporations less appealing for small businesses. They don't get the Section 199A deduction, and the 21% flat tax rate is actually higher than the 15% many small businesses used to pay.

California's Rules for LLCs

If you're in California and your business needs a state license, you can't form an LLC. The problem is, the state has never actually published a list of which licenses count as "professional" versus "nonprofessional." So, if your business needs a state license that hasn't been specifically ruled on, you're taking a gamble that your LLC might get invalidated later. This usually comes up during lawsuits, which is exactly when you don't want to deal with it.

Contractors can get licenses for LLCs, but the company must either carry $1 million in liability insurance or have $500,000 in cash on hand. So really - only bigger contracting companies are going to go this route.

Writing Off Business Losses

In partnerships, LLCs, and S corporations, when the business loses money (or makes money), it flows through to the owners' personal tax returns. You can deduct those losses if you have enough "basis" in the business - think of basis as how much you've invested in the business.

Partners and LLC members can count their share of company debt toward their basis, so they can claim more losses. S corporation shareholders can't count company debt unless they personally loaned the money to the company. This is one big reason why it's usually a bad idea to hold rental real estate in an S corporation.

California's Extra Fee

California LLCs that bring in $250,000 or more have to pay an extra fee that ranges from $900 to $11,790. Corporations don't pay this fee. That means if your business makes more than $250,000, corporations start looking better than LLCs.

Other Things to Think About

There are lots of other factors that might influence your choice, like employee benefits, whether you might be considered a personal service corporation, personal holding company rules, foreign owners, wanting a different year-end than December 31st, keeping cash in the company, and estate planning.

You can find more details about the differences between LLCs and S corporations here.