1099 is no longer being updated, but please enjoy our archives.





Add Feedback






It can certainly be scary: trying to choose a legal structure for your business can seem like confronting a horrible, two-headed monster. One head goes by the name "sole proprietor," while the other is called "corporation." You're not sure which is scarier, and you hope the beast will vanish if you close your eyes and count to ten.

No such luck. In fact, if you don't make a decision, the IRS (speaking of monsters) will do it for you, and you don't want that. You're an IP; you make decisions for yourself.

A sole proprietorship is a business wholly owned by one person, who's known as a sole proprietor. The sole proprietor, moreover, owns all the business' assets in his own name. This means that there's no legal distinction between the sole proprietor's personal and professional possessions.

By contrast, a corporation is a business owned by one or more people, called shareholders. The corporation is treated like a fictional person, a made-up thing that has the power to act, and can therefore assume some of the responsibility for its actions. A corporation can own assets, buy and sell them, hire and fire people, make and lose money, sue and be sued.

In this introduction to business structures, we aim to uncover why you might want to operate as one and not the other. We'll describe the basics of sole proprietorships and corporations; tell you the major advantages and disadvantages of each; and, we hope, get you to think of the choice among business structures as a business opportunity instead of a monster to be wished away.

Sole Proprietorships

Sole proprietor is the very simplest business structure: it's what you are if you go into business without doing anything official, a kind of default mode. Legally, the business and the sole proprietor are one and the same. The business' assets are the personal possessions of the sole proprietor, the business' risks are the proprietor's risks, and the business' taxes are recorded simply as an addendum (the Schedule C) to the proprietor's personal tax return. Most IPs operate as sole proprietors.

The Good News

Easy to establish. A few states require sole proprietors to register the name under which they plan to do business or to get a business license, but this isn't much trouble. Fill out a single form and you're done. In most cases all you have to do to be a sole proprietor is own all the business' assets in your own name.

Pay taxes only once. This is a biggie. Because you are your business, you pay income taxes only once -- as an individual. The business does not pay taxes separately. (Your individual tax return includes a Schedule C for your sole proprietor business. You don't fill out a separate corporate return.) We'll soon see that this isn't the case for some types of corporations.

No boss. If you own the business, you're officially the boss, plain and simple.

The Not-So-Good News

Lots of liability. As the sole owner of the business and its assets, you're personally and completely responsible -- that is, legally liable -- for the actions of the business. A legal settlement against you could cost you the business' assets and your personal ones as well. In fact, legally, there's no difference between the two.

The Corporation

If the informality and potential liability of operating a sole proprietorship makes you uncomfortable, consider incorporating your business. To have "incorporated" means that you've filed special papers to create a business that is technically a separate entity from yourself. As we said, a corporation is legally a fictional person. This entity has assets that are separate from your personal assets, can make or lose money separate from your personal savings, and incurs risk (of being sued, for example). The corporation does all these things independently of the person or people who own the corporation, and consequently must also file a special set of tax returns independent from the shareholder's or shareholders' personal returns.

The two basic types of corporation are the S Corporation (S Corp) and the C Corporation (C Corp). In most respects they're identical, so before we discuss the principal difference between them -- the way they're taxed -- let's consider the advantages and disadvantages of the corporation in general.

The Good News

Liability Protection. Because the corporation exists as a legal entity that typically assumes responsibility for the actions of its shareholders and employees, the corporation is also legally liable for them (unless they're criminal acts). If a company fails to pay a debt, for example, the creditor may sue the corporation for payment. If the creditor wins the lawsuit, the court may seize the corporation's assets to pay the debt, but not the assets of the shareholders and employees. A corporation shields its shareholders' personal assets. (Keep in mind, however, that a corporation won't provide you with complete immunity from personal liability; liability insurance might still be a good idea.)


Some IPs think that their businesses will seem more official and therefore garner more business if the abbreviations "Inc." or "Co." follow the name of the business (Sour Sadie's Sex Toys, Inc.). Others say that their experience and skills speak well enough for them. At the very least, incorporating your business suggests that you're committed to it.

The Not-So-Good-News

Paperwork. Regardless of the kind of corporation you form, you will need to keep more detailed records than the sole proprietor does. The corporation owner(s) must be able to prove that the business is (and remains) a corporation and not some other kind of business, which might be subject to different laws. The distinction becomes especially significant in court: if a judge determines that a corporation's assets are really just the personal property of the corporation owner, for example, the judge can declare the corporation a sham and force the owner to use his personal assets to pay the "corporation's" debt. This is called "piercing the corporate veil."

To form a corporation, you file papers with the Secretary of State of the state where you will do business. These papers (Articles of Incorporation, a Certificate of Incorporation, or a Charter) identify the corporation and its principal players by name. (As a formality, corporations must have shareholders, directors, and officers. Although these positions may, in most states, all be held by one person, they must nonetheless be filled.) Later you'll draw up bylaws, which describe the rules that will govern the operation of the company.

Additional Expenses. Because the corporate structure is more complicated than a sole proprietorship, you will probably need to consult a lawyer and perhaps an accountant as well. Although you're not required to get professional counsel, it's probably a good idea. This represents an additional expense.

Liability Counterargument. Even if you're incorporated, you're not invincible. Clients can try to make you sign their contracts "as an individual," and not as an incorporated business. If the type beneath your name on the contract says "as an individual," you lose the liability protection of incorporation, which was the main reason you incorporated in the first place. Clients will not necessarily try to make you sign as an individual, of course, and when they do, you always have the option to refuse.

The Corporate Taxation Game

As we've already mentioned, the C Corp and the S Corp differ primarily with respect to the way they're taxed. It's a pretty big difference and would probably be the reason you would choose to form an S Corp (which is the form of choice for most IPs who incorporate) rather than a C Corp (which is typically the business structure of choice for big companies with lots of shareholders).

C Corp

In a sense, the money of the C Corp shareholder always gets taxed twice. Yes, that's right, a C Corp's revenue is subject to double taxation. The C Corp pays its own taxes, then may pay a part of the remainder to you, the shareholder, as dividends. You would pay personal income tax on your share of the dividends. (IP C Corps don't usually bother with dividends. Instead, these IPs pay themselves a salary, which comes with its own considerations: corporate and personal tax brackets sometimes differ, and the difference may affect the amount of the salary paid.)

For Further Research

Choosing a Legal Structure for Your Business by Stuart A. Handmaker

How to Incorporate
by Michael R. Diamond and Julie L. Williams

How to Incorporate and Start a Business in [Your State]
by J.W. Dicks

A Legal Roadmap for Consultants by Judy Gedge

Starting a Limited Liability Company
by Martin M. Shenkman, et. al.

Tax Guide for Small Business
" by the IRS (publication 334)

Starting a Business and Keeping Records
" by the IRS (publication 583)

S Corp

By contrast, the S Corp pays taxes only once -- through you, the individual shareholder. You file only one tax return, a personal tax return, just as you did before you incorporated. There is no corporate tax return to file. All income is treated as your income, which means that you file a personal tax return and pay personal income tax on the money you derive from your stake in the company, just as in a sole proprietorship.

The obvious benefits of this are simplicity and one-time taxation. An additional benefit becomes clear if we imagine that your company (heaven forbid) loses money one year. In this event, you may deduct the amount of your loss on your personal income tax statement.

Beware of the flip side, however: if the S Corp is unable to use its income to pay the shareholders -- because the money must be reinvested in the company to meet expenses anticipated in the coming year, for example -- the shareholders must still pay taxes on their share of the income, even though they never actually received a penny of it.

The Limited Liability Company (LLC)

The LLC is essentially part corporation, part sole proprietorship. In the eyes of the law the LLC, like a corporation, is viewed as a person -- a legal entity independent of its owners. This means that it can enter into contracts, buy and sell products and services, make and lose money, sue and be sued. In short, the LLC provides its owners (who are called "members") with a degree of liability protection. Unlike the C Corp (but like the sole proprietorship and S Corp), the LLC does not pay taxes. Its income is passed along to the members, who report their share of the LLC's income on their personal tax returns.

The Good News

No Double Taxes. Like the S Corp, the LLC itself does not pay taxes; its members do, on their share of the income.

Liability Protection. As a member of an LLC, you can take actions that bind the LLC (for example, contracting with an outside vendor to deliver a hundred jelly doughnuts to the office every day for a year) and not be held personally liable for the action. Your personal assets are separate from the business' assets, and therefore safe, more or less to the degree that the assets of a corporation's owner are safe. (You are, however, responsible to the other members of the LLC for your actions. If they think you've acted frivolously or with disregard for the interests of the company, you might find yourself in an awkward situation.)

The Not-So-Good News

Limited control. To underscore a fact that may discourage die-hard solo workers, many states require LLCs to have at least two members. You can't have a one-person LLC. (And in most states, a member of an LLC can't sell his interest in the company unless the other members unanimously approve of the transaction.)

Bureaucracy. Forming an LLC will mean writing and filing a lot of documents, most importantly the Articles of Organization and the Operating Agreement. The Operating Agreement is the more complicated of the two, and among the subjects it must cover are weird things like the circumstances in which the LLC will not be automatically dissolved.

Feeling Better?

Having shed some light on the two-headed monster, we hope that you don't find him as intimidating as before. If you want to really flood the creature with light and see his wrinkles and pores in detail, we suggest that you consult a good lawyer.

November 22, 1999
Written by 1099 Staff
Illustrator: Lawrence San
Production: Keith Gendel

We'd love to hear your comments about this article!


Go to top of this page

Entire contents Copyright © 2000 1099 Magazine. All rights reserved.
The 1099 name and logo are trademarks of 1099 Magazine.