Select the Suitable Legal Entity for your Business
There may be many options depending on your country, but it might not be as hard to choose as it appears. In fact, this may be one of the easier decisions you have to make. In many countries, a business can be formed as a sole proprietorship, limited liability company, limited partnership, or a corporation. Very often, a form of limited liability company is the appropriate choice for small businesses.
The form of business ownership has legal and tax implications. In many countries, there are at least three forms of business ownership.
You could start a business as a sole proprietor. This requires paperwork, and it is not required to create a separate legal entity. In this structure, the owner and the business have the same identity for legal and tax purposes. All of the income or losses from this business flow directly to your personal income tax return.
The biggest disadvantage (it is a really big one!) is that your personal assets are exposed if someone decides to sue your business.
To set up a sole proprietorship, all you need to do is start doing business. There are no legal or tax requirements; however, you must obtain required permits or licenses to abide by local, regional, or federal laws.
You could set up a corporation that is a separate legal entity. This corporation will file its own income tax returns. Any profits will be distributed to owners as dividends. The biggest drawback of this option is double taxation: the profits from this business are taxed on its own income tax returns, and the dividends paid to the owners are also taxed on the tax returns of the owners.
This is also a big disadvantage, especially for small businesses that need to distribute income to the owners.
This could be an appropriate business structure for you if you intend to re-invest the profits back into the company to support its growth. If dividends are not paid to the owners, then no taxes will have to be paid on the dividend income; hence there won't be double taxation. Eventually, when you do decide to pay out some dividends, the dividend income will be subject to personal income tax.
Limited Liability Company with Tax Benefits
In most countries, there are one or more forms of corporations that have tax benefits. They offer the best of both worlds: limited liability with no double taxation. In the US, there are LLCs, limited partnerships, or S-Corps which offer some of these advantages. Often, for small businesses, this is the most suitable legal structure.
There are subtle differences between various forms of limited liability companies and tax-advantaged corporations. Please contact your lawyer or accountant before making any firm decisions on this issue.
SBA small business website is a great resource for understanding more about forms of business ownership.