Marty has a small bookshop, only three months old. His losses from the shop flow through his sole proprietorship to shelter most of his royalty income. When the shop becomes profitable in a few years, and lower corporate income tax rates begin to look better than the 50 percent personal income tax bracket, he plans to incorporate. But not now.
Marty knows that people rarely get sued for selling a dangerous book, so he isn't concerned about liability. He doesn't have extensive property that he wants to protect from business creditors. And he likes the simplicity and control of the sole-proprietorship form.
Other entrepreneurs like the fact that a sole proprietorship can be set up quickly and easily. All they need do is register the name with the city or county clerk and pay a nominal fee for whatever licenses are required.
The sole proprietorship is less expensive to set up than a partnership or a corporation, and government regulations and tax forms are simpler.
So why doesn't everyone stick with a sole proprietorship?
With a sole proprietorship, you have sole responsibility. You may not be able to take an extended vacation, unless you have someone you trust to run the business in your absence.
Anything that takes you away from your business for a long time can put it in jeopardy. And you have unlimited liability for all business debts, which can gobble up your personal assets. It's harder to get financing for sole proprietorship, too.
A partnership takes more time and legal help to set up. It includes co-ownership of the profits, shared management, and unlimited liability for at least one partner.
Your partner can help you make decisions and come up with the starting capital. He or she may also have skills that complement yours, blending to build a stronger company. And you can feel freer to take longer vacations, if your partner doesn't go with you.
But the first time you end up buying a company car that looks as if it belongs at the Indianapolis Speedway rather than in front of your office, or have a disagreement over the future of the business, you may wish you had stuck to a sole proprietorship or a corporation.
Corporations are not simple legal structures. In fact, Colquitt Meacham of the Boston law firm Benjamin, Meacham & Benson estimates that it costs about $1,000 in fees to lawyers and accountants alone just to get set up. Ms. Meacham stresses that a few dollars spent at the beginning can save you some costly legal mistakes down the road.
For small businesses that can't afford even those fees, there are books, often with tear-out forms, available to tell you how to incorporate without a lawyer.
The most important advantage of a corporation is the limited legal liability. If your business is sued or is over its head in debt, creditors cannot take away your cherished baby grand piano. Income taxes on higher amounts are lower, too, and lenders look more favorably on your request for capital.
You will be able to set up company benefits for yourself and others in your business, such as company cars, pension plans, and insurance.
But (and you knew this was coming, right?) there is a lot more paper work. Suddenly Uncle Sam is noticing you as never before, and it's not the right kind of attention. Also, you can no longer reduce your personal taxable income by your business losses (except through a Subchapter S corporation.)
Be prepared for stockholder meetings, drawing up of bylaws, issuing stock, and declaring dividends.
The Subchapter S corporation combines the best features of the sole proprietorship and the corporation if your business has losses or low profits. Business losses flow through to reduce your personal taxable income. But your personal liability is still limited.
A Subchapter S corporation can have no more than 10 shareholders, no nonresident-alien shareholders, and only one class of outstanding stock. All shareholders must agree to form the Subchapter S, and a portion of the corporation's income must come from business activity rather than passive investments.
The decision to incorporate is usually made when profits are high enough that incorporation will reduce taxes, or when the liability protection a corporation offers becomes desirable.
At what point incorporation will reduce taxes depends on a lot of things, including what your personal income is. To find out where your incorporation point is, consult an SBA counselor or an accountant.