There’s much more to starting a business than coming up with the best idea since the invention of sliced bread, writing a business plan and finding investment capital or using a credit card. A would-be Internet Entrepreneur also must decide how his or her business should be structured from a legal and tax point of view. My own business is set up as a Limited Liability Company which protects my personal assets as long as I follow some easy rules (strictly SEPARATE business and personal income/expense no matter what).

But depending on your business model, you can chose between sole proprietor, partnership, LLC, and incorporation (including its small-business sibling, the S chapter corporation) and get a better (or worse) business implementation. In my case a LLC offers more legal protection than a partnership, but retains the tax pass-through characteristics of a partnership or corporation in many regards. Since I am the only member of my LLC I do not have to worry about anything related to the partnership. Like the other choices, setting up a LLC has its pluses and minuses. Although individual circumstances will affect your personal situation, here’s a small report or review that should help you find the best solution that works for you.

LLC - Limited Liability Company

Advantages: LLCs, like corporations, provide the business owners with liability protection. Only company assets can be targeted by debtors, but not your personal assets. That is an important step up from partnerships and sole proprietorships where your personal assets may be vulnerable to settle a business debt or liability. Unlike corporations, LLCs don’t suffer from double-taxation, in which the corporate entity is taxed and then its shareholders’ dividends are taxed as well. This benefit applies to LLCs that are classified as partnerships for tax purposes, but can affect you on a personal level with a higher tax rate (if you also have income from other sources). Your earnings or losses pass through to you - the owner and are included on your personal tax return. If you are like me and still have a full-time job, your earnings from the LLC go on top of that and can push you into a higher tax bracket. The problem is that your entire income from the LLC is affected, while your personal income from a corporation only affects that income you pull out. There’s also a lot less paperwork involved with running an LLC than a formal corporation: No meeting minutes, No year-end minutes, no notification of shareholders of meetings and so on affect a LLC. Finally, LLCs are the most flexible way of setting up a business when it comes to organizational structure. For example, fewer rules exist regarding who can be a shareholder. They also tend to be more informally run than a regular corporation. This leaves some room if you plan on bringing in a partner later down the road.

Disadvantages: Tax liability for an LLC varies by state. So if your company is going to operate in several different states (with local offices that is), you’ll have to know the different requirements before choosing this type of business structure. A LLC also can’t go public if you plan on doing so. Otherwise, you’ll have to switch your company from being a LLC to being a corporation.

The cost of launching a LLC also varies by state. Some states charge significantly more for starting (and maintaining) a LLC than to incorporate. A few states even charge special annual fees for LLCs. Finally some states require two or more partners for an LLC so if you’re going into business solo, this business format is not for you. When I started my LLC here in Colorado, the setup fee was $50.00 and the annual license fee is at about $25 or so. I think California charges some around $800.00 to set up and LLC (I have not verified this, but you get the idea).

Incorporation

If you start a new business and want to incorporate, you can form a C corporation or an S corporation. According to some press reports, the number of S corporations that are being registered for business is actually surpassing the setup of C corporations. Reason for that could be because of the advantages inherent with starting a S corporation. Most businesses just starting out will opt for the S classification from what I can tell.

Advantages: Unlike LLCs, both S corporations and C corporations can go public if required. For that reason, most venture capital companies prefer to work with corporations rather than with LLCs. A “S corporation”, like the LLC, don’t suffer from double taxation. C corporations may face double taxation, however they can have incentive stock option plans or other ways to distribute the profits. Depending on what your plan is, it can also make sense to keep the profits inside the corporation and shelter them from your personal tax rate. This allows you to pick a time when releasing the profits to the shareholders and eventually pick a time of lower personal income from other sources (lower personal tax rate).

Disadvantages of corporations: As mentioned previously, C corporations face double-taxation, but S corporations also have drawbacks to be considered. The biggest disadvantage is that the number of shareholders that an S corporation can have is capped at 35. This might not affect most (small business) Internet Entrepreneurs though, but should at least be known when planning for the best business structure. In addition, there are limitations on who can be a shareholder in an S corporation. S corporations can’t have another corporation or a foreigner as a shareholder. If you would be looking for investment capital this would make this business structure difficult to use. Both S and C corporations require more ongoing paperwork than an LLC. Corporations must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes and hold shareholder meetings and votes on major corporate decisions. While this is fairly easy to do when it’s just you, it still requires a lot of work and efforts - time you eventually could spend on better things.

Which business structure is really right for you?
Sitting down with your lawyer and your tax accountant is probably the best way to sort through the tax and organizational issues and figure out what’s the best organizational structure for your company. This adds an additional cost to your startup expenses and can easily reach low 4-figures.

This next part is not for everyone. If you feel competent enough, you can incorporate your business or form a LLC on your own. This step requires checking with your state’s corporate filing office (usually the Secretary of State or Department of Revenue) and filling out all the forms available at the filing office or available from your state’s website. When I set up my LLC the employee I worked with at the Secretary of State offices was extremely helpful and corrected some of the small mistakes I had made or missed fields to fill-out. I had also used the “contact us” option that the website of the State of Colorado had (has) in place and got detailed answers back. You already guessed it I assume - yes, I did do the “Do it Yourself” LLC setup.

There are also 3rd party web sites and service providers that offer/promise to make business formation a matter of filling in the blanks. However, if you have any doubts/concerns or your business organizing process takes a complicated twist, don’t do it alone - spend the money and enlist the aid of professionals. Filing incorporation papers should cost between $50 and $1,000, depending on your state. This does not include any legal fees for lawyers or tax accountants.

Important: You’ll also need to check with federal and state trademark registries to determine whether the business name you have decided on for your company is available and not already chosen and protected. Most states offer an online database for that purpose. Once you decided on a name, but are not ready to file for business, you can “reserve” the name for future use. The fees associated with that should be less than $100 depending on the state you live in. If you want to incorporate, you will also have to complete corporate bylaws, which outline when the annual shareholder meetings will be held, who can vote, how shareholders will be informed if there’s a need to additional meetings, and so on.

Choosing the wrong business formation can hurt you financially and legally down the road. Spend enough time on reviewing your needs and make an informed decision. Also, consider owning more than one business if you want to protect certain pieces of your empire. If you move into areas where legal risks are involved, start a separate business entity to protect your other business assets.

Disclaimer: This posting shall not replace any legal advice nor does it assume that it is 100% legally correct. It is based on my own personal experience and research I did. Your mileage might vary. Please hire a lawyer or accountant if you are unsure.