Choosing a Business Structure

Your home-based business will take one of three basic forms: a sole proprietorship, a partnership, or a corporation. Each of these forms has its pros and cons, and you'll need to decide which is best for your situation.

Sole Proprietorship

This is the easiest structure to adopt for a business. You're the owner — the sole owner — of the business, and from a legal and tax perspective, there's no difference between you and the business. As the sole owner, you get to make all the decisions and keep all the profits.

The good news is that starting and operating a sole proprietorship — and ending it — is relatively straightforward. The bad news is that if your business fails, all of your personal assets are on the line: You have what's referred to as unlimited liability. Creditors are free to come after your house, car, antique furniture, and savings accounts, for example. And because you're self-employed, you don't qualify for unemployment insurance or worker's compensation.

Although this can be a sobering thought, it's still a logical choice for many businesses, especially when you are the business. In fact, if your home is the business's address, and if you're borrowing money using personal assets such as your home as collateral, trying to separate yourself from the business for liability purposes (by incorporating, for example) might not even be possible.

According to the SBA, more than 90 percent of all home-based businesses in the United States report that they are sole proprietorships — they're run by one person, and have no paid employees. The statistics aren't as clear in Canada, but at least 50 percent are likely sole proprietorships.

Partnership

When you combine forces with another person (or people) in business, you've created a partnership — essentially, a multiparty or dual proprietorship in which each party is self-employed. This tends to be the choice of many husband-and-wife teams.

A partnership is easy to organize, much like a sole proprietorship, and has the same drawback in terms of unlimited liability for each partner. This is important, because it means you can be held responsible for the business's debts based on a mistake that one of your partners has made.

You can also create a limited partnership, in which one partner (the general partner) has unlimited liability, and the others have limited liability (often the same amount that they've invested in the partnership). Essentially, a limited partner is an investor, while the general partner operates the business.

It's critical to outline the partnership agreement ahead of time, when everyone is in a positive frame of mind. Agree on paper each person's responsibilities, duties, investments, and profit shares — and on an exit strategy, to handle the process if one partner wants out, or if the entire business is going to be dissolved. If things get ugly later, at least the contract will be clear.

If you're considering a partnership — even with a family member — you should sit down with a lawyer to formalize the partnership agreement once you've decided on the basics of how the business is going to operate. Consider the legal fees an investment in your future.

Incorporation

Corporations are legal entities that are separate from their owners. On the plus side, this means that shareholders have limited liability in the case of business losses or failures (although if the business can't be separated legally from an individual who owns the corporation, this can be challenged in court). Corporations are taxed on their own income, while shareholders pay tax on their salaries and dividends.

Forming a corporation — incorporating — is more complex than a sole proprietorship or partnership, and it's more expensive to create and maintain. But, if you foresee considerable growth, extensive outside investment, and significant risk for the business, forming a corporation might be worthwhile.

Limited Liability

For home-based businesses in the United States, Chapter S Corporations might be a better choice if you want to incorporate. Geared for small businesses, an S Corp doesn't pay tax on its income: Instead, income and expenses are divided among the shareholders, who then report them on their own income tax returns. Unlike a partnership, however, liability is limited. In a way, this business structure provides you with the best of both worlds.

However, there are stringent record-keeping and reporting standards for S Corps (that translates into bookkeeping expenses), so for most home-based businesses, an S Corp might be unnecessary. It's possible, though, to convert a sole proprietorship or partnership to an S Corp in the future.

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