By Larry Melillo

Creating a new business is an exciting undertaking for any personal financial advisor. One of the first tasks you'll need to address is to determine the best legal structure for your new business. Selecting the appropriate business structure will help you find the best way to treat income and assets. Choosing an inappropriate business structure could place you at personal risk for the company's losses and subject your organization to unnecessary taxes.

Read on to learn the types of legal structures available for new businesses, as well as the pros and cons worth considering when determining which business structure is right for you.

Types of legal structures

A small business owner can choose from five legal business structures. These business structures have different characteristics related to:

• Ease of creation and ongoing maintenance
• Treatment of income, assets, and liabilities
• Legal protection from risk
• Treatment of taxes

Sole proprietorship

A sole proprietorship is an unincorporated business that is owned by one person. It is the simplest form of business organization to start and maintain.

A sole proprietorship has no existence independent from the owner. As such, the liabilities of the business become the owner's personal liabilities. From a tax standpoint, the income and expenses of the business are included on the owner's individual tax return.

Partnership

A partnership is a formal relationship between two or more people who join together to form a business. Each person in the partnership contributes money, other assets, skills, and/or labor. In return, each partner expects to share in the profits and losses of the business.

Unlike a sole proprietorship, a partnership must file an annual return to report the income, deductions, gains, and losses from its operations. However, a partnership benefits from pass-through taxation — it does not pay income tax. Instead, profits or losses pass directly to its partners. The partners, in turn, report income gains or losses from the partnership on their individual tax returns.

Corporation

When forming a corporation (also known as C corporation), prospective shareholders exchange money, assets, or both for shares of ownership, reflected by the corporation's stock. Managed by a board of directors elected by the shareholders, a corporation protects its shareholders from the debts of the corporation (although not from all legal risks). Creating a corporation can be both expensive and time-consuming, making it an unattractive structure for most new businesses.

The corporation pays a tax on its profits. And if profits are distributed to shareholders as dividends, the shareholders pay taxes on these profits according to the dividends that they received. This is often referred to as double taxation.

When calculating its taxable income, a corporation generally takes the same deductions as a sole proprietorship. A corporation can also file for special tax deductions, and the complexity of these deductions often requires the advice of tax professionals who specialize in corporate tax law.

S corporation

Similar to a corporation (although slightly less onerous to form), S corporations avoid double taxation by electing to be treated as a special entity. To reach such status, S corporations are required to have less than 75 shareholders. S corporations are exempt from federal income tax other than tax on certain capital gains and passive income. Shareholders file their share of the corporation's income, deductions, and losses on their individual tax returns.

Limited liability company

In a limited liability company (LLC), owners have limited personal liability for the debts and actions of the business, similar to shareholders in a corporation. Other features of LLCs resemble a partnership — LLCs permit management flexibility and the benefit of pass-through taxation.

Owners of an LLC are called members. Unlike S corporations, there is no maximum number of members required for an LLC. LLCs are relatively easy to form when compared with C and S corporations.

Questions to consider before selecting a legal structure

The process of selecting a legal structure can be complex, involving an understanding of law, taxes, and organizational structures. Before making a choice, consider consulting with accounting and legal professionals to help you understand the pros and cons of your different options. Like personal financial advisors, such professionals likely are already members of your personal network.

Address these basic questions before selecting your business structure:

How many owners are starting the business? How many people may become owners in 3 years? In 10 years?

The number of owners at the startup of a business will immediately narrow your business structure options. If you plan to have more than two owners, a sole proprietorship is ruled out; if you plan to have more than 75 owners, an S corporation is not an option.

Perhaps a more important issue for you to consider is how you expect your business to grow over time. For example, if you want to start a financial advisory business that you intend to manage on your own indefinitely, a sole proprietorship may work well. However, if at some point you desire to expand your business, you may need to take on additional partners, shareholders, or members. From the inception of your business, you'll need to create the appropriate legal structure that permits this kind of growth without resulting in penalties or excess taxes.

When is a partnership an ideal choice of structure?

Partnerships are ideal when there are a limited number of people who choose to accept different levels of control. Owners with less control typically contribute less startup capital or ongoing effort, but they also receive fewer of the organization's profits (or losses).

A partnership agreement typically defines general partners and limited partners. General partners are the primary owners who have responsibility for running the organization. Limited partners may provide capital to help start the business, but they are not heavily involved in day-to-day operations.

If your business employs from 2 to 75 people, why choose an LLC over an S corporation or a partnership?

In recent years, LLCs have become the structure of choice for many new small businesses. State laws generally make LLCs relatively easier to set up than S corporations. But more importantly, a member of an LLC may be actively engaged in the management of the business and yet may retain limited liability. In contrast, a partner in a partnership who is actively engaged in management may become personally liable for the debts and actions of the business.

Will your business ever go public?

IRS conversion rules may impose harsh tax penalties on LLCs or partnerships that decide to go public. If you expect your business to go public in the future, an S or C corporation may be a better choice.

When creating a new business, explore the different legal structures available for your circumstances. With the right business structure in place, you'll reap tax and legal protection benefits. Just as importantly, you'll gain the flexibility to change the operating model of your company in the future, without incurring wasted effort and expense.

About the author   Larry Melillo is a manager at KPMG's CFO Advisory Services. CFO Advisory Services professionals help organizations implement strategies and process changes that drive a more value-added finance function.