Should I Incorporate or Form a Partnership?

Many individuals starting a business ask: (1) Should I incorporate my business? (2) Am I better off creating a partnership?

There's no easy answer and it all depends on what choices you want to make given what is appropriate to your business, but you may wish to consider several key factors.

First, corporations generally have limited liability, which means that with a few important caveats, the owner-shareholders have limited liability for the corporation's debts or judgments against the corporation. Limited liability means that the owners are not personally liable if someone sues the corporation; they are only liable up to the limit of their capital investment in the corporation.

There are tax advantages and disadvantages to corporations and it is wise to consult a tax accountant. For one thing, the rates of federal and state taxation differ for corporations and sole proprietorships. Also, in a sole propietorship, profits and losses from the business flow through directly to the owner's personal tax return, typically on a Schedule C; whereas in a corporation, the dividends that the corporation pays to shareholders are not deductible from business income, which means that this part of the corporation's income can be taxed twice.

Corporations have shares and are governed by a certificate of incorporation and bylaws, among other documents. Bylaws establish time, place, and manner of meetings; duties of officers and directors; voting rights; and other such important matters.

Partnerships are governed by a partnership agreement between the partners. It is essential to have a partnership agreement that sets out the rights and obligations of the partners. Too often "friends" or "business acquaintances" operate with an "understanding," not memorialized in a legally binding writing, and that can lead to trouble if the relationship deterioriates during a dispute. Much better to be clear about such things as: how much each partner will bring to the partnership and how profits and losses will be allocated; how the partners will make key decisions; what they will do in case of a deadlock; how they will resolve disputes; how they will admit future partners to the partnership; and how one partner can buy out another's partnership interest.

Whereas owners of corporations, as mentioned, typically have limited liability, in a partnership, each partner is jointly and individually liable for the actions of every other partner.

There are general partnerships, in which partners divide responsibility for management and liability, as well as the shares of profit or loss; and limited partnerships, in which the general partners manage, and the limited partners have limited authority to manage and liability typically limited to their investment in the partnership.

One option is the hybrid vehicle known as the limited liability corporation (LLC). LLC's combine some of the features of corporations and partnerships. The LLC can offer the limited liability of a corporation with the pass-through tax benefits and operational structure of a partnership.

The right structure is an individual choice, and it depends on many factors, including the level of growth projected for the company, the level of control one wishes to have over its management, tax considerations, and protection against liability.