Small businesses have a unique appeal in American life. The ideal of the self-made entrepreneur calls people to start over 600,000 small businesses each year. The Small Business Administration estimates that more than 627,000 businesses were started in 2008. (1) The downside of small business creation is that the majority of business fail the first year. In 2008 alone almost 600,000 firms failed. (2) According to the Commerce Department, only seven out of 10 firms last longer than two years. Only five out of 10 businesses survive five years. (3)
Starting a small business is a complex task and requires internal strength, diligence and persistence. The legal structure of the business plays a large role in determining funding and the level of taxation. The wrong legal structure can kill a business before it even opens it's doors. Properly incorporating the business when setting it up can even potentially save the owner from bankruptcy in the long run.
The small business owner is the business under this legal set-up. The owner legally represents the company. This simple structure creates minimal tax complications, has much lower start-up costs and makes it easier to handle funds and profits. Unfortunately, since the owner and the company are legally one and the same, creditors can sue the owner for the debts of the business. There is no legal separation between the owner's liability and the business's liability. The owner himself will have to file for bankruptcy if he cannot meet his business obligations.
Under this plan, taxation is similar to a sole proprietorship. There is no corporate tax rate, which makes this structure very attractive. Profits and losses become part of the owner's personal income and are taxed at the owner's applicable rate. An S corporation also allows the owner to write off any losses incurred when starting the business. The biggest downside is the requirement of maintaining regular meetings between shareholders and keeping minutes from these meetings.
This is a more complex version of the S corporation structure. C corporations are the legal structure behind the popular image of a corporation. A board of directors decides company policy and shareholders own different classes of corporate stock. C corporations are taxed at a separate rate and their income is legally separated from the owner's personal income. Owners cannot write off start-up losses. The complexity and responsibility of a C corporation is enough to persuade most small business owners of choosing another legal plan.
Limited Liability Company
A limited liability company (LLC) is probably the most ideal structure for a small business. The owners of an LLC are legally separate from the company. Consequently, the owner is not liable for business debts and creditors cannot sue him to recover them. Profits and losses pass through to the owner's personal income. The operating costs of an LLC are much lower because no meetings, minutes or boards are required. The downside is that an LLC dies when it's owner either dies or goes bankrupt.