Setting Up a Business Structure

After getting laid off from a senior engineering job last year, Marc Karell launched a consulting business from his home in Mamaroneck, N.Y. But before he landed a single client, the unemployment benefits he had been relying on to make ends meet came to a sudden halt.

The reason: He established his venture, Climate Change & Environmental Services, as a limited liability company, or LLC.

Mr. Karell says that had he known the move would mean an end to his layoff benefits, “I probably would’ve held off on being an LLC for a little while.”

Deciding what kind of legal structure to form for your new business — and when to do it — may require more research and consideration than other tasks. Rules regarding eligibility to collect unemployment benefits vary by state, as do the costs associated with setting up the various types of entities. And each option has distinct tax, liability and administrative implications.

“You have to understand the ramifications of choosing one form or another or none at all,” says Matthew S. Gilman of Boston law firm Pepper Hamilton.

In general, most small businesses are structured into one of five basic forms: a sole proprietorship, partnership, C corporation, S corporation or limited liability company.

You don’t need to file paperwork to establish a sole proprietorship, which is a business that’s owned by one person or a husband-and-wife team. The same goes for partnerships, defined as enterprises with two or more nonmarried owners. For this reason, these options are typically the least expensive — though most states and cities do require entrepreneurs to obtain a license or permit to operate and will charge various fees.

C corporations, S corporations and LLCs, which differ by their tax structure, require filing paperwork. C corporations typically pay taxes twice — first on all income that’s left after business expenses are paid and again on that income when it’s distributed as dividends to shareholders. S corporations allow profits to pass through to the owners’ personal tax returns. For tax purposes, LLCs must elect to file their tax returns as a C corporation, S corporation, partnership or sole proprietorship.

A major downside to sole proprietorships and partnerships is that they lack liability protection. So owners’ personal assets could be at risk should their companies get sued.

AmyLynn Keimach and her business partner, Kenneth Tran, have yet to establish a legal structure that offers liability protection for Border7 Studios, a Web-services firm they launched in 2008. Ms. Keimach says they can’t afford the costs associated with electing to form an S corporation, their desired legal structure, in part because they started the Simi Valley, Calif., company after getting laid off without severance pay.

For now, the two are operating Border7 Studios as a partnership — and hoping they don’t run into any legal problems with their roughly 20 clients. “If they sue our company, they could take everything me and my partner own,” says Ms. Keimach. “It’s scary.”

Jennifer Chu wants to make her one-year-old business, Chu Shu, an S corporation in part because she says the tax structure would be more beneficial to the company. But Ms. Chu says she learned a costly lesson by not electing S-corporation status in time to apply those benefits to her New York business’s 2009 tax returns.

“I didn’t realize there was a deadline,” says Ms. Shu, who was laid off from an investment-bank just prior to launching her firm, a maker of odor-absorbing liners for women’s shoes.

The IRS requires that businesses elect to become an S corporation by March 15 of any given year to gain any tax benefits associated with that status for that year’s tax returns. And to elect S-corporation status, most businesses must first be either a C corporation or an LLC.

Overlooking the March 15 deadline “could cause a small-business owner to miss out on thousands in tax savings,” says Brian Wendroff, managing partner for Wendroff & Associates, an Arlington, Va., accounting firm.

When setting up a business entity, entrepreneurs also face the cost of hiring an accountant or lawyer to handle the paperwork involved. But some business owners may be able to take on the job themselves or use Web services like MyCorporation.com, BizFilings.com and LegalZoom.com.

On such sites, you pick the state where your business is based, the business structure you want and the required forms are provided. And you can fill those out and send them through the site. You also get customer-service support. The services cost an average minimum of about $95.

Rick Dunaj says he initially sought an attorney’s help in establishing his Los Angeles marketing start-up, Dunaj Agency, as an LLC in 2008. But the fee he was quoted — roughly $6,000 — was more than he could afford.

“When you’re starting your own business and need to be very conservative with the capital you’re putting in, that’s a lot of money,” says Mr. Dunaj, who left a firm in the same industry to go out on his own because a layoff was on the horizon. So he turned to MyCorporation.com, where he paid about $200 to get the job done.

While these websites offer guidance in choosing a legal structure, experts suggest consulting with an attorney and tax professional for advice specific to your business.

—For more tips on launching a venture, go to wsj.com/smallbusiness. Email: sarah.needleman@wsj.com

Corrections & Amplifications LLC stands for limited liability company. An earlier version of this article incorrectly referred this business structure as a corporation.