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Sole Proprietorship vs. Corporation: Why Your Legal Structure Matters

by Claire Parker, Staples® Contributing Writer

Say your company is a sole proprietorship and it gets sued. Your personal assets are fair game for lawyers. So how do you best protect your business and yourself?

If you’re worried about the structure of your entity or confused about the pros and cons of sole proprietorship vs. corporation, then it’s time to see what legal and business experts advise when it comes to protecting your assets.

Sole Proprietorship

“The pros of a sole proprietorship are that there are no formal filing requirements — you simply get started,” says lawyer Shane Fischer of Winter Park, FL. Taxes are easy, since all business income is reported on your personal income taxes, and the income is all yours.

But that’s where the advantages start to fade. Sole proprietors have unlimited personal liability for the business and must pay a self-employment tax. That’s no way to protect your assets or your business. Fischer rarely recommends operating this way. “The costs and paperwork associated with incorporating/forming an LLC are minimal compared to the benefits they provide,” he says.

Partnership

Partnerships are easy to launch but come with similar pros and cons. There aren’t many required documents to get started, so partners must outline the terms of profit, ownership, etc., themselves. Formal partnership agreements are critical. These agreements can move to other structures if you ever change your business model.

“There are frequently a lot of disagreements over management and control over the business, which could hurt business performance,” Fischer says. “You're a fool if [a partner] only contributes 25 percent of the money but is allowed to control more than 25 percent of the corporation.”

Similar to sole proprietorships, partnerships don't benefit from many expense deductions and owners have unlimited personal liability for the business. Again, this is probably not the most effective way to protect your personal assets.

LLC

“In general, limited liability companies are the preferred type of entity due to the tremendous asset protection benefits afforded them,” says Lindsey Page Markus, a principal at the Chicago law firm of Chuhak & Tecson.

However, that doesn’t mean an LLC will perfectly protect your business or your personal assets. Operating agreements vary from state to state. Be sure to check with your state’s Secretary of State or your business attorney to find out the specific requirements.

If you need further protection, know there is flexibility. “The entity can elect to be taxed as a partnership, where all tax liabilities flow through to the respective members. Alternatively, the LLC can make an S-election to be taxed as an S corporation. This allows for maximum asset protection with minimum taxation,” Markus says.

But once you become an LLC, it is difficult to change course to another structure, so research all forms of incorporation to ensure you are protecting your business properly.

S and C Corporations

S and C corporations loosen up the protection of your business slightly but offer more expense deductions and enable the corporation to survive the owner’s death. “The S corporation is the preferred form for many small businesses. The S corporation is similar in structure to that of a C corporation, but it must meet a few further requirements,” explains lawyer Ramsey A. Bahrawy of the Bahrawy Law Office in North Andover, MA.

You can avoid double taxation (when corporate profits are taxed as both dividends and distributions to owners) as an S corporation but not as a C corporation. Both structures require more time and money to get started and require more legal filings.

These are complicated matters, and the more advice you can get, the better. Talk to lawyers, accountants and business advisors to get the lowdown on all the pros and cons of sole proprietorship vs. corporations, including new regulations and state laws. Then decide which is the best way to protect your assets.

Otherwise, your hard work could be wasted. “If you don't, a creditor can pierce the corporate veil and come after your personal assets,” says Fischer, “negating the protection that comes with owning a corporation.”

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