Business Incorporation -- How to Move from the World of Unlimited Liability to Limited Liability

For the small business owner or self-employed person, both the sole proprietorship and the general partnership put you in the world of unlimited liability.

All your personal assets are at risk. A business-related accident or lawsuit could literally wipe you out.

How do you solve this problem? By forming a "C" Corporation, an "S" Corporation, or a Limited Liability Company (LLC).

Here's a quick overview of the major characteristics of these three entities:

C Corporation. The profit of a "C" Corporation is taxed twice -- once to the corporation and a second time to the shareholders when distributed as dividends. (This is the dreaded "double taxation of corporate profits"). However, shareholders cannot deduct any losses of the Corporation. The "C" Corporation files Form 1120 to report its income and expenses to the IRS.

S Corporation. If your business qualifies, it can avoid double taxation by becoming an "S" Corporation. An "S" Corporation generally is exempt from federal income tax, but still must file an income tax return called Form 1120S. The income or loss of the "S" Corporation is transferred from the corporation to the individual shareholder's personal income tax returns via Schedule K-1, which the corporation must give to each shareholder.

Limited Liability Company (LLC). This is the newest entity type. From a legal standpoint, the LLC is much like a corporation, offering limited liability to the owners (which are called "members"). From a tax standpoint, the LLC is like a chameleon -- it can be taxed however it wants to be taxed, provided the proper paperwork is filed with the IRS. If there is only one owner/member, the LLC can be taxed like a sole proprietorship, a "C" Corporation, or an "S" Corporation. If there are two or more owners/members, the LLC can be taxed like a Partnership, a "C" Corporation, or an "S" Corporation.

Please note that I'm leaving the limited partnership out of this discussion. I'm assuming that you want a say in the day-to-day management of your business. If so, then both the general partnership and the limited partnership are not a good Choice of Entity for you. Why is that? Because if your business is a general partnership, then you automatically have unlimited liability. And if your business is a limited partnership and you want management control, then you're going to have to be the general partner, and again, you'll have unlimited liability.

There are certainly business situations for which the limited partnership is a "good fit" (for example, if real estate is involved). But that's beyond the scope of this article.

So, back to my original question:

How do you avoid unlimited liability? By forming one of these entities: a "C" Corp, an "S" Corp, or a LLC.

Having made such a bold statement, let me also say this: when it comes to this choice of entity issue, one size does not fit all.

So let me add a strong disclaimer: there are situations where a "C" Corporation, an "S" Corporation, or a LLC is not appropriate.

But generally speaking, for many small business owners and self-employed people, one of these three entities is the best fit.

Remaining a sole proprietor or a general partnership doesn't make much sense -- you are putting yourself, your family, and all your personally owned assets at risk.