Before you start a new business, there are a number of preliminary decisions you need to make. First you need to determine the legal form in which you will operate the business. Should you operate an unincorporated sole proprietorship, a partnership, a limited liability company, a regular corporation, or an S corporation? Each form has advantages and disadvantages that you must weigh in combination with your own plans and personal situation.

Sole proprietorships, for example, are the easiest and cheapest business form to set up. Although they can be operated with few formalities, they offer no personal liability protection and don’t allow many of the tax benefits that are available to corporate employees.  Net income is subject to individual income tax PLUS 15.3% self-employment or SE tax (Social Security and Medicare).

Partnerships offer many of the same advantages and disadvantages as the sole proprietorship, but they allow the business to be owned and operated by more than one person. In addition, the liability problem can be overcome to a certain extent by forming a limited partnership. Partners whose liability is limited cannot be involved in actively managing the business, and losses from limited partnerships may be restricted by the passive activity rules.  General partners also pay SE tax on their share of partnership income.

A limited liability company (LLC), which is approved for use in almost every state, offers what many see as the best alternative for the typical small business. LLC's with more than one member are taxed as partnerships, avoiding the corporate income tax, while the managing members’ personal assets remain fully protected from business creditors. The LLC can also elect to be taxed as a corporation. Single-member LLC's are taxed as sole proprietorships by default. They can, however, elect to be taxed as a corporation.

S corporations also offer liability protection, without a separate corporate tax. Like partners and sole proprietors, however, more than two percent of S corporation shareholders are ineligible for tax-favored fringe benefits. Another potential drawback of S corporations results from limitations on the number and kind of permissible shareholders. These restrictions can limit an S corporation’s growth potential and access to capital in some businesses.  Shareholder/employees must be paid a "reasonable" salary in compensation for their work for the business.  However shareholders can also receive part of the business profit as distributions which are not subject to SE tax.

The remaining choice is a C corporation. These entities do not have the shareholder restrictions that apply to S corporations, but they are subject to a double system of taxation. Put another way, the corporate profits are subject to income tax at the corporate level and are also taxed to the shareholders if distributed as dividends. But if profits remain in the business to further the company’s growth, the tax consequence is usually lower than with an S corporation. There are many situations, however, in which the double tax can be substantially minimized. The biggest advantage to this form of operation is that shareholder-employees are entitled to tax-advantaged fringe benefits, such as medical coverage, disability insurance, and group-term life.