The Best Way to Incorporate Your Small Business

In reference to undertaking a new and arduous endeavor, Chinese philosopher Lao-tzu is quoted as saying, "A journey of a thousand miles begins with a single step."

If he were reincarnated as a modern accountant or business lawyer, he might tell a client about to start another type of new and arduous endeavor, "The key to a successful small business is choosing the right legal entity."

These entities vary widely in terms of difficulty to create and maintain, as well as in their tax and legal advantages. Knowing which one will work best for you -- and when you might need to change it -- can often be confusing, so let's take a closer look at four of the most common types.

Sole Proprietor

Structure: An unincorporated business owned and run by one individual.

Difficulty: This is the simplest, least expensive and least painful way to start a business. Just the act of conducting commerce qualifies you as a sole proprietor, though you will have to obtain certain licenses and permits, depending on which state you are in.

Pros: It only involves one person (you) so you don't have to worry about anybody else telling you what to do. As sole proprietor, you can arbitrarily decide when to start your business and when to terminate it, and if you die, it automatically ceases to exist.

Taxes are simple as there is no difference between you and your business –- you are taxed as one entity –- reporting your gains and losses with a Schedule C on your personal income taxes.

Cons: Because you are considered the same entity, you have unlimited personal liability, meaning if your business causes harm, either financially or physically, you are responsible for it.

General Partnership

Structure: An unincorporated single business where two or more people share ownership.

Difficulty: It's as simple to start as a sole proprietor. Just start doing business and acquire the appropriate state licenses and permits. The only additional step, which is not mandatory but advised, is to have a written agreement between partners.

Pros: In a healthy partnership, the division of labor can relieve the pressure of one owner having to carry all the business responsibilities.

Cons: In an unhealthy partnership, individual perceptions can form as to which partner is doing more work than the other, leading to tensions that can adversely affect your business. There is a reason they say that the best two days of a partnership are the first and the last.

Limited Liability Company

Structure: A hybrid legal structure that provides the limited-liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.

Difficulty: This is where things get a bit more complex. In order to create an LLC, you must choose a name that complies with your state's LLC rules, file articles of organization, pay a filing fee, create an LLC operating agreement covering the rights and responsibilities of the LLC members, publish your intent to form an LLC and obtain the permits and licenses required for all businesses in your state.

Pros: Like the name implies, members of the LLC are personally shielded in most cases from any liabilities incurred by the business. And compared to an S-Corp, there is less registration and operational paperwork, yet more favorable tax advantages than a sole proprietorship or general partnership.

Cons: One of the few drawbacks to an LLC is its limited life span. If one member leaves, the business is dissolved and existing members must fulfill all remaining obligations to close the business. The remaining members can decide if they want to start a new LLC to replace the closed one.

Subchapter S Corporation (S-Corp)

Structure: A corporation created through an Internal Revenue Service tax election.

Difficulty: First, you must create a corporation by choosing a name that complies with your state's rules, appointing your initial directors, filing articles of incorporation, paying a filing fee, creating corporate bylaws, holding your first board meeting, issuing shares to the owners of the corporation and obtaining the permits and licenses required of all businesses in your state. Then you must determine if you meet the requirements for an S-corp, and if so, take that election with the IRS.

%VIRTUAL-article-sponsoredlinks%Pros: An S-corp is considered to have an "independent life" separate from its shareholders, which provides the most protection against personal liability and allows shareholders to come and go without affecting the continuity of the business.

The tax advantages of an S-corp are better than an LLC as a portion of the business' profits can be paid to the owner as a distribution, which is taxed at lower rates than wages.

Cons: The operational obligations of an S-corp are the most onerous, requiring scheduled board of director and shareholder meetings, minutes from those meetings and strict record keeping related to adoption and updates of bylaws as well as stock purchases, sales and transfers.

Which Is Best and When?

Starting out as a single owner with a low-liability business, a sole proprietor is by far the best entity to begin with. Then if you elect to add a partner in the future, it is virtually seamless to transform into a general partnership.

Once you start to earn annual revenues of $20,000 to $30,000, you should think about converting your sole proprietorship or partnership into an LLC, where tax benefits will be more advantageous. Moving to an LLC should also be considered if your business begins to operate in a way that increases your liabilities because it shields your personal assets.

A move to an S-corp -- which provides the highest level of liability protection and tax flexibility -- should be considered when your business earns enough revenue to justify having an employee dedicated to keeping your company in compliance with all corporate laws and regulations.

No man is an island, or even a peninsula, so I encourage your feedback in the comments below. And don't forget to pick up my book, "Trading: The Best of the Best -- Top Trading Tips for Our Time."