Every business has a legal format that defines its ownership structure and how its profits will be taxed. Here's a brief comparison of the formats typically used by creative firms in the United States. In order to choose the most appropriate format for your business, you'll have to carefully weigh a number of important trade-offs: the ease or difficulty of set-up, the level of business taxation and the extent of your personal liability for business debts and obligations. Ask your attorney and your accountant for guidance in selecting the right format.

Sole proprietor
When you first start working on your own, your business is, by default, a sole proprietorship. You don't need to do anything special to set up an unincorporated business that's owned and managed by one person. No legal formation documents need to be filed with any governmental agency. For tax purposes, the Internal Revenue Service considers a sole proprietor and his or her business to be one entity. Business profits are not taxed separately. They are reported and taxed on your personal tax return, using your Social Security number. This single level of taxation is the major benefit of a sole proprietorship. The major disadvantage is that you have unlimited personal liability for all business debts and obligations. If something goes wrong, you're on the hook and you could lose personal assets such as your savings, house, or car.

General partnership
A partnership can be easy to establish as well. A partnership is defined as a voluntary association of two or more people to carry on a business as co-owners for profit. They don't necessarily need to file any formal paperwork to do this. There are two basic types of partnerships -- general partnerships and limited partnerships. If you don't file any paperwork, you've automatically formed a general partnership. In a general partnership, all partners participate to some extent in the day-to-day management of the business.

For taxation purposes, the company is not considered separate from its general partners. This means that the business itself does not pay taxes on profits. Instead, the partnership "passes through" the profits or losses to each partner, based on percentage of ownership. Each partner then reports his or her share on an individual tax return. This single taxation is one of the benefits of selecting a general partnership as your legal format.

General partnerships have a downside, however. Because a general partnership is inseparable from its owners from a legal standpoint, the partners are jointly liable for the entire amount of any business-related contracts, debts or other obligations.

Limited partnership
The other basic type of partnership is a limited partnership. It's a bit more complex and expensive to set up than a general partnership because a limited partnership becomes a separate legal entity from the partners themselves. It's comprised of one or more general partners and one or more limited partners. The general partners control the company's day-to-day operations and are personally liable for the partnership's debts and obligations. This is in contrast to the limited partners, who are passive investors. They contribute capital and they share in profits, but they cannot be involved in the management of the company. They have no right to bind the partnership to contracts or other obligations. Because of this, the personal liability of a limited partner is capped at the amount of his or her investment.

In the next article, we'll discuss other common legal formats including "C" corporations, "S" corporations, and limited liability companies.

Did you find this column helpful? Click here to rate it!