Every business owner has to make a decision on the legal organization that the business will take. There are several different types of legal entities to choose from and each one has different liability and tax consequences. Among the different choices are sole proprietorships, S corporations, C corporations, limited liability companies, and partnerships.

A sole proprietor is simply an individual transacting business. The law makes no distinction between the individual owner and the business. The liability and tax consequences associated with a sole proprietorship stem from this important element. While it is the simplest type of organization, it provides the individual with the least liability protection and the least flexibility come tax time.

The individual operating a sole proprietorship incurs unlimited personal liability for all of the business debts. If the business is liable on a contract, or negligently causes personal or property damage, the individual's personal assets can be used to pay the debt. This could include not only business assets, but also personal investments, automobiles, and any other assets that the owner may have.

Because the law makes no distinction between the individual owner and the business, there are some tax advantages (and disadvantages) to operating as a sole proprietor.

The first advantage is that sole proprietors are not subject to double taxation, which occurs in C corporations. The profits of the business are reported on the individual's tax return only. When a C corporation makes a profit, the corporation declares dividends and pays a tax on that profit. The owners, or shareholders, of the corporation also pay income tax on the income derived from the dividends. This is called double taxation.

The second advantage occurs if the business takes a loss in any given year. Since most start up businesses lose money in the first year, this can be significant. The loss that the business takes can be used to offset any other income that the owner has for that year, including wages, interest, or investment income. If the owner files a joint return with a spouse, the spouse's income can be offset as well.

The law makes no distinction between the partnership business and the partners. Because this structure is much like a sole proprietor, the liability and tax consequences are similar. A partnership occurs when there are two or more partners who share profits of a business. A partnership does not exist when an individual merely pays wages to an employee out of business income. There must be a verbal or written agreement to share profits before a partnership will occur.

Because the partners may be personally liable for the debts incurred by any other partner acting in the scope of the partnership, this is the riskiest form of business. Businesses operating as partnerships should seriously consider some sort of liability protection, including incorporating the business.

A corporation can have one or more owners. Most states permit one person to be the only owner, director, and officer of the corporation. Massachusetts is one of the few states that require at least two people to be named in the Articles of Incorporation.

A corporation transacts business through its directors and officers. Ultimately, decision making is vested in the shareholders of a corporation. The board of directors are elected by the shareholders to act as decision makers. The officers of the corporation make day to day decisions and sign all official documents on behalf of the corporation. Officers are required to act at the will of the board of directors. In small companies in most states, one person can be the shareholder, director and only officer of the corporation. This is often the case for entrepreneurs in their first few years.

The important distinction between a sole proprietor and a corporation is that a corporation is treated as a separate entity apart from its owners. If a business incurs debt beyond it resources, the owners do not incur any liability beyond their capital contribution to the company. Any judgments against a corporation are limited to corporate assets. The indivudual's personal investments and outside income are protected.

Because they are treated as separate entities, C corporations pay an entity level tax and are possibly subject to double taxation. If a C corporation pays a dividend the actual take home income of the owner may be reduced to less than 50% of the profits, with the majority going to the IRS.

Section 1361 of the Internal Revenue Code allows small businesses to make an election to be an S corporation. Among the requirements to be eligible for S corporation status is that the corporation be owned by 75 or fewer legal permanent residents of the United States. This is the case for most entrepreneurs. An S corporation maintains the identical liability protection that a C corporation enjoys, but does not have to pay the double taxation. S corporations are commonly called pass-through entities because the profits pass through to the shareholders, without being taxed at the corporate level.

Larger companies, including all publicly traded companies, have more than 75 shareholders, excluding them from eligibility for S corporation status.

The owner of an S corporation can limit the amount of FICA tax it pays by engaging in a widely accepted practice called wage reduction. While sole proprietors pay self-employment tax on all earned income, the owner of an S corporation only pays Social Security tax on wages, not dividends. An individual owner/employee can pay a reduced (but reasonable) wage and declare a FICA-free dividend. For a complete understanding of wage reduction consult your CPA or attorney. Many entrepreneurs benefit by filing the appropriate forms and making the S-election.

LLC's are the newest type of business entity. For that reason, the laws surrounding them are uncertain and rapidly changing. Generally, an LLC maintains the limited liability that a corporation enjoys, but is a taxed like a partnership. Like an S corporation, an LLC is a pass-through entity.

LLC's do not have the strict ownership requirements that exist for S corporations. There is no limit on the number or the character of owners of an LLC. An LLC can be owned by any combination of U.S. or non-U.S. residents, corporations, and other LLC's. Because of the rapidly changing law regarding LLC's, many attorneys and CPA's shy away from recommending that their clients choose this type of business entity. Others welcome the uncertainty to take advantage of the tax and liability protection available in all states.

Choosing a business entity can have very serious tax and liability consequences and the most important thing is that the owner make an informed decision. Every business is different and what may be good for one company may not be for another. You may want to consult a professional in this field if you are unsure of what is best for you.