What's the Best Corporate Structure to Protect Small Business Owners?

When business takes a turn for the worse—the debts become unmanageable, say, or it's hit with a punishing legal judgment—the outcome could be disastrous for your personal finances. Unless you've chosen a business structure to insulate you from such bad fortune.

The owners of limited liability companies, limited partnerships, and corporations are usually only liable up to the amount they invested in the business. Creditors and plaintiffs can’t go after the owners’ personal assets.

Which of these alternatives should you choose? One consideration is taxes: Whether they're levied before or after profits are distributed to owners, and how selling the business might affect them. Another is the nature and number of the company's owners.

Once you choose a structure, realize that switching it into another type is hard. You might be tempted to change if you believe that you’ll get a better tax benefit, but the tax code discourages such shifts.

With that in mind, here are the most common choices:

Limited and limited liability partnerships. A limited partnership is a pass-through entity. This means that all profits, losses, credits, and deductions flow through to each member's individual tax return. The partnership structure avoids a major downside of corporate taxation, where earnings are taxed twice, first at the corporate level and then on the remainder distributed to shareholders as dividends.

With a limited partnership, only owners with active control of the business, known as general partners, are liable. Limited partners, those who have only put up capital and stay out of company affairs, have liability protection.

But in limited liability partnerships, all of the partners have liability protection. Usually, they all share management responsibilities. The LLPs are typically used by professional practices, such as doctors, lawyers, and accountants. Indeed, some states restrict LLPs to professional organizations.

Subchapter C Corporation. This is the classic American corporation—and most small business owners avoid it because of the double taxation problem. On the other hand, there's no limit on the number of C-corp shareholders, who can normally trade that stock freely.

All this makes the C-corp a better vehicle than a partnership for taking a company public or doing a tax-free merger through a stock swap (where the acquirer trades its stock for that of target-company shareholders). And unlike the owners of some other entities, a C-corp shareholder managing the business can distinguish between the personal income earned as profits from that earned as salary, owing payroll taxes (Social Security and Medicare) only on the latter.

Subchapter S Corporation. Like an LLP, this structure is a pass-through entity and avoids the double tax bite. One S-Corp advantage is that it’s easier for owners to sell the business outright–and they also fare better financially. The problem with a cash sale for a C-corp is that the proceeds are treated as ordinary income, which usually carries a higher rate than does a capital gains transaction. So owners get nicked twice. The owners of a pass-through entity, like an S-corp, pay only individual capital gains tax.

Further, an S-corp retains some of the features that make a corporation attractive—among them: liability protection, freely traded shares, and the distinction between profit and wages.

On the minus side, the tax code places strict limits on which business can qualify for the designation. Ownership in an S-corp, for example, is restricted to at most 100 U.S. shareholders (a family can count as a single shareholder), with one class of stock. Normally, an S-corp can neither own another business, nor be owned by one. And an S-corp cannot deduct the cost of benefits provided to all but the smallest employee-owners.

Limited liability company. Like an S-corp, an LLC marries the pass-through nature of a partnership with the corporation's liability protection. Simply dissolving the firm, though, can be more advantageous with an LLC than either a C or S corporation. When an LLC's assets are distributed to its members upon dissolution, the Internal Revenue Service doesn't count it as a taxable transaction. Rather, members pay tax only later if they sell those assets.

Also, an LLC is much more flexible than an S-corp. In most states, no limit exists on the number of its owners, which can usually include businesses, even foreign ones. An LLC can also set its own terms for distributing income among members–unlike a corporation, it doesn't have to treat all investors equally.

As always, there are tradeoffs. An LLC member pays self-employment tax–which can be as high as 15.3%–on all the income passed through from the company, including profit. And while in some states, LLC members can sell their stake without the consent of their co-owners, elsewhere they are only free to sell their stake in the profits. Selling their control as managers requires the approval of other members.

Should you start a new business, it’s worthwhile to see which variety of ownership will benefit your situation.