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Tax laws provide flexibility-choose wisely:

February 27, 2006

When starting a business, entrepreneurs must make a multitude of decisions and research countless topics, from the demographics of the target market to the color scheme of the company logo.

One of the most fundamental decisions demands careful analysis: choosing the legal form the company will take.

Small-business owners have a great deal of flexibility in choosing a structure, but the decision could affect the tax burden imposed by the federal government.

Consider three basic structures: proprietorship, partnership and corporation.

Both proprietorships and partnerships are unincorporated; the major difference, of course, is that a proprietorship has one owner while a partnership has more.

In many cases, these businesses have no formal state charter, although they may be subject to business license rules. They often have federal identification numbers for payroll- and excise-tax purposes.

These entities are not subject to federal income tax, but the owners must include business income-and other income and deductions-on their personal tax returns.

Corporations are more complex, with two main types: C and S corporations

A C corporation computes its taxable income separately from its owners. If a corporation has positive income, it is liable for its own income tax.

Publicly held companies have this tax status, but C corporations can have a single owner, too. Distributions from these corporations typically are dividends, which recipients must report as taxable income even though the corporation also reports it.

More than half of incorporated businesses file returns as S corporations, which means they are not liable for federal income tax and avoid this "double taxation."

Shareholders each claim their own portions of the corporation's income and losses. They may be able to deduct the corporation's losses, although several complicated limitations apply to deductions.

Entities must meet stringent rules to be treated as an S corporation. Compliance can be burdensome and should not be attempted without professional assistance.

An S corporation also can't have more than 100 shareholders, but there are ways to count members of an extended family as a single shareholder.

Another option is organizing as a limited liability company. For state law purposes, the most important feature of the LLC is that the owners are protected from business creditors, in the same manner as if they were shareholders in a corporation.

However, the limited liability company lacks many of the formalities of the corporation, such as the need for annual meetings and boards of directors. The lack of formality can be a mixed blessing, especially if investors want to see rights and responsibilities specifically enumerated and regulated.

Another point to realize is that individual owners, whether they are members of an LLC or shareholders in a corporation, may have to guarantee some of the company's obligations.

For federal tax purposes, the LLC has the ultimate flexibility. It can choose to be a C corporation or an S corporation, or it can be treated as unincorporated.

Entrepreneurs have many options when choosing a business structure, depending on the needs of owners and investors. It's always best to fnd good legal and tax advice before making these crucial decisions.



Jamison is a professor of accounting at IU's Kelley School of Business in Indianapolis and a former tax department manager at Ernst & Young.
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