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Choosing Your Form of Business

Does your business "suit" you? As with any good clothes, what’s right for you is what fits. The right organizational form for your business depends on how much control you want, how you want to use revenues and what type of protection you need from liability claims — to name a few.

In this Quick-Read, you will find:

  • How business-entity types differ.
  • How tax concepts can influence your choice of entity.
  • How non-tax-related considerations influence your choice of business organization.

Understand: this is only a thumbnail sketch! Always consult your legal counsel.


The sole proprietorship is the way to go if you want to incur no fees or formalities in setting up your business. You’re your own boss and you have fewer reporting and regulatory requirements. The major problem here is you’re personally liable for all obligations of the business and for all actions you and your employees take on behalf of the business. And when you die or retire, the business goes too.

A partnership consists of two or more people or business entities. No formalities are required, and it can even be formed by an implied rather than express agreement of partners to associate for profit. General partners usually have equal voices in management. Major decisions usually require unanimous vote; ordinary decisions, simple majority. Profits and losses are usually taken by the partners in proportion to their stakes in the business, whether they contributed services or cash. If one partner takes unauthorized action, the others can be obligated. If a general partner dies, goes bankrupt, withdraws from the business, or is forced out by the others, the partnership dissolves. The basic advantage of a limited partnership is that the limited partners’ liability for business obligations is limited to the extent of their capital contributions. But their roles are limited too. Forming a limited partnership can require considerable filing formalities.

A corporation has a "life of its own" when properly formed through formalities prescribed by your state. It can exist in perpetuity, and ownership can be transferred from one shareholder to another more freely than with partnerships. Shareholder liability is limited, and shareholders don’t actually own corporate assets: the corporation does. Filing fees, taxes, by-laws and minutes of organizational meetings are a must. Some states require minimum capitalization.

The "C" corporation is taxed on earnings. When earnings are distributed as dividends, shareholders are also taxed on that money. Double taxation can be avoided if your corporation meets the tests for an "S" corporation. Soon after it’s formed, file IRS Form 2553 (and applicable state forms). Shareholders of an "S" corporation — not the corporation itself — are taxed as in a partnership. But it must have a limited number of shareholders. They all must agree to do this. None can be a nonresident alien. There can be only one class of stock outstanding. There’s a limit on the percentage of gross receipts that can come from rents, royalties, interest and dividends. There are other requirements too. Shareholder liability is limited.

Limited liability corporations (LLC) offer similar advantages as the "S" corporation, but there’s no limit on the number of shareholders. And better than a limited partnership, where at least one general partner must be fully liable for partnership debts, the LLC limits the liability of its members. Technicalities must be followed to make it legal, such as name requirements, written articles of organization — which must be published in a couple of newspapers for a specified period of time, written operating agreement and a filing fee. The members can dissolve it, and unless they agree to continue it, it will dissolve on its own when a member dies, withdraws, becomes bankrupt, incapacitated or expelled. If it conducts business in a state that doesn’t recognize the LLC, the owners risk losing their liability protection. But nearly all states recognize the LLC status.

Professional partnerships are increasingly filing as limited liability partnerships (LLP). Each partner, employee or agent can be held accountable for misconduct or negligence of anyone directly under him or her, but no partner is liable for debts of the LLP or any other partner while registered as an LLP.

Tax Comparisons

The sole proprietor reports income on Schedule C of Form 1040. Business expenses are deductible and losses can offset other income to reduce personal taxes. Partnership members are taxed individually in proportion to their stakes in the business. They can offset business losses from other income sources. By electing "S" status, a corporation’s shareholders can enjoy the same tax treatment as partners, with the advantage of liability protection that partners generally don’t have. Members of limited liability corporations can also enjoy partners’ tax advantages with liability protection. "C" corporations are subject to "double taxation" but may deduct "reasonable" business-related expenses.

Caveat: Before changing your form of business, check with your attorney and tax adviser for possible tax consequences of transferring assets from one type of business entity to another.

Non-tax Considerations

The ultimate in control is the sole proprietorship. You make the decisions and you are liable for all obligations. When you bow out, the business ends. If your business needs money to grow, a lender will look to you alone to prove you’re worth the risk. If someone else is "in" on the venture and you expect to have business expenses early on that could help offset other income, consider a partnership. Unless you specifically agree to limit the liability and can meet technical requirements, your liability for partnership obligations could be a drawback.

If you like the liability protection of a corporation and you share ownership, consider the "S" corporation or the LLC. The LLC is not limited in the number and type of shareholders it can have as the "S" corporation is. Be prepared for the technicalities and fees to set up and maintain a corporation of any kind. The business expenses you incur, like buying or leasing real estate or equipment or paying salaries and fringe benefits, can be deducted if the taxing authority considers them "reasonable."


When Christopher Avery founded Partnerwerks in 1990, he and his partners decided an "S" corporation was the business form that best fit their organizational performance consulting company’s needs.

"An ‘S’ corp allowed us to legally separate the liability of the company and the liability of the owners, which a sole proprietorship doesn’t do," Avery recalls. "It allowed us to keep simple books and accounting, which a partnership or ‘C’ corp couldn’t do. And it didn’t create a separate tax entity, so the tax consequences flowed through directly to the owners in proportion to ownership."

Today privately held Partnerwerks — which has two employees
and uses outside consultants and contractors — operates as a "C" corporation in Comfort, Texas. Avery, who has been sole owner for five years, made the switch in 1997.

"Our accountant presented us with a scenario where our health insurance would cost less if we switched to a ‘C’ corp — that’s what started it," Avery says. Also, he had tired of playing "hide the check" at year’s end. "S" corporations, he explains, run on a cash accounting system, which makes ending the year "with a zero bottom line" a goal.

"In November and December, checks you receive from clients you hide in a drawer, then cash them on January 1," Avery laughs.

"C" corporations, however, rely on accrual accounting, and they’re usually in a lower tax bracket than profitable "S" corporation owners, Avery notes. "You don’t have to play ‘hide the check’ anymore, and you can have more stable cash flow from the beginning to the end of the year."

Making the switch was easy. Avery filed a simple form with the state and informed the IRS of Partnerwerks’ new status at tax time. Though the change has been positive overall, running a "C" corporation has presented challenges.

The biggest issue has been learning to deal with accrual accounting. "You look at the balance sheet or set of books, and the numbers there don’t match the numbers in your checking account. I still have to stare at it until it comes into focus and makes sense," Avery says.

A corollary problem: the inability to compare year-to-date numbers. "We were scratching our heads, and then realized we were trying to compare apples to oranges because you can’t compare cash and accrual systems," he notes.

While Avery enjoys the lower-cost health benefits and the fact he and Partnerwerks are separate tax entities, his "C" corporation status isn’t set in stone.

"It’s very fluid. Every year we review it to see if we’re better off as an ‘S’ or a ‘C’ corp. It depends on changes in the tax code, our situation, and the benefits we want to take advantage of," Avery concludes.

DO IT [top]

  1. Ask yourself these questions:
    • Is my primary goal saving taxes, decision control, expansion or continuity of the business?
    • If taxes are key, is it more important to distribute earnings to co-owners or plow resources back into the business?
    • If it’s more important to limit liability, do I have the temperament to maintain paperwork of a corporation or limited partnership, that is, filing requirements, voting procedures, operating agreements, by-laws and tax filings?
  2. Is my current form of business serving me well? Don’t be pressured to change. Serious tax consequences could result. Check with your lawyer and tax adviser before making a move.
  3. Do I foresee a problem? Laws are complex, and even the small print in contracts doesn’t tell the whole story. You can inadvertently obligate yourself and undermine your firm’s foundations. Your accountant is trained to help you paint a factual picture of your financial status. Your lawyer is trained to anticipate problems while they’re small. Consult them early and often.



J.K. Lasser’s Small Business Taxes, 6th ed., by Barbara Weltman, Esq. (John Wiley & Sons, 2003).


Tax Guide for Small Business: Publication 334. U.S. Internal Revenue Service, annual. Sole Proprietorships.
Partnerships: Publication 541. U.S. Internal Revenue Service, annual.
Corporations: Publication 542. U.S. Internal Revenue Service, annual.
Starting a Business and Keeping Records: Publication 583. U.S. Internal Revenue Service, annual.

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Article Contributors

Writer: Beverly M. Poppell and Kathy Furore