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PEOPLE PROBABLY TELL you all the time that you should incorporate your small business "for tax reasons" or to protect your personal assets against business-related liabilities. Despite folklore to the contrary, setting up a corporation might not give you a huge advantage. In fact, you may want to consider an increasingly popular alternative: the limited liability company (LLC). Corporations and LLCs are treated differently, tax-wise — and neither is a cure-all when it comes to liability protection. So which is right for your small business? In a nutshell, here's what you need to know about the two most common small-business entity options.

What's the Difference?

By state law, a corporation is considered a separate "person." Therefore, when you use a corporation to own and operate your business — with you acting as a shareholder and employee — your personal assets (such as your home, investments, and retirement accounts) are generally protected from business-related liabilities. The corporation's assets, if any, are at risk. But your personal stuff is sheltered.

By state law, an LLC is also considered a separate "person." Therefore, you generally get about the same liability-protection benefits if you operate as an LLC instead of incorporating. If you're the sole owner, you'll have what's known as a single-member LLC, or SMLLC.

Understand this: Legally speaking, corporations and LLCs are not the same thing. While they are similar in some ways, the liability protections offered by each depend on complying with applicable state corporation law or applicable state LLC law.

Now for the bad news. A corporation generally won't protect your personal assets from liabilities caused by your own professional malpractice or negligence. Nor will incorporating protect you from liabilities resulting from your own tortious acts, whether you commit them on business or not. Tortious acts are legal misdeeds that don't have to do with contractual matters. An example is injuring someone or causing property damage by driving your car carelessly. An LLC (or SMLLC) generally won't protect you against these types of liabilities either. Therefore, you'll probably still need business insurance coverage to adequately insulate yourself against risk.

Key Points to Remember About Business Entities

Both corporations and LLCs offer liability-protection benefits, but they are not cure-alls. Neither will protect your personal assets from liabilities related to your own professional screw-ups or legal misdeeds.

From a tax perspective, LLCs are simpler than corporations, and SMLLCs are extremely simple. For a profitable business, however, the S corporation alternative may allow you to minimize the dreaded Social Security and Medicare taxes. Check with your tax adviser about which is best.

And naturally, a corporation or LLC won't protect you from debts that you personally guarantee.

The good news is a corporation or LLC generally will protect your personal assets in other situations — such as from liabilities caused by those who work for you. Note that a few states and some professional licensing bodies don't allow LLCs for certain types of activities (for example, accounting and banking) which leaves incorporation as the only liability-limiting option for affected businesses.

What's the bottom line? Since being in business can expose you to liabilities in so many unforeseen ways, running your shop as a corporation or LLC is generally advisable. In my opinion, it's a no-brainer if you have employees or independent contractors working on your behalf. They can cause liabilities in ways you could never even imagine.

Here's what you need to know, tax-wise, about corporations and LLCs:

Corporations

If you incorporate, you'll have to file a separate federal income tax return for the corporation each year, and maybe a state return too. You'll generally want to elect S corporation status to avoid paying any corporate-level federal income tax. Under the S corporation rules, all income, deductions and tax credits from the business are passed through to the shareholders who then take these items into account on their personal Form 1040s. If you don't make the S election, your corporation will be taxed under the so-called C corporation rules, which means the corporation itself will owe tax if it has positive taxable income. Then you'll also owe tax on your own Form 1040 if the corporation pays out profits to the shareholder(s) as corporate dividends. Using an S corporation avoids the potentially disastrous threat of double taxation.

Operating as an S corporation can also allow you to minimize the dreaded Social Security and Medicare taxes by paying yourself a relatively modest, but still reasonable, salary. Social Security and Medicare taxes are only due on your stated salary, as long as it's reasonable. You can then withdraw additional cash flow from the business in the form of employment-tax-free S corporation distributions. This is all good, but you may need a tax pro to handle the additional corporate tax filings and paperwork.

LLCs

If you have an LLC with more than one owner, it's generally treated as a partnership for federal tax purposes. Under the partnership rules, all income, deductions and tax credits from the business are passed through to the owners. Each owner then takes these passed-through tax items into account on his or her Form 1040.

So you don't have to worry about double taxation with an LLC (which is good), but you must still file an annual return with the IRS and maybe with your state too. All things considered, however, the tax-related paperwork is less with an LLC than with a corporation. Even so, you might want to hire a tax pro to keep things straight.

Probably the biggest disadvantage of running as an LLC is that all of your net business income may be exposed to the dreaded self-employment (SE) tax. For 2007, the SE tax rate is 15.3% on the first $97,500 of SE income. That 15.3% rate covers both Social Security and Medicare taxes. The SE tax rate on income above $97,500 is 2.9%, which is for Medicare tax only. Of course, the SE tax is not a major concern unless your business earns a healthy profit. If it does, consider the S corporation alternative to minimize Social Security and Medicare taxes. If you have a husband-wife LLC, click here for some SE-tax-reduction ideas.

Tax-wise, operating your solely-owned business as a single-member LLC (SMLLC) is super simple. The IRS allows you to report all the business income, deductions, and tax credits directly on your Form 1040, which typically means filling out Schedule C (the same document that's used by sole proprietors). In other words, there's no need to file a separate business return with the Feds. Ditto for most states. The biggest downside of using an SMLLC is that all of your net business income may be exposed to the dreaded SE tax (at the rate of 15.3% on the first $97,500 of SE income and 2.9% on any SE income above $97,500). Once again, the SE tax is not a big issue unless your business earns a healthy profit — in which case you should consider a solely-owned S corporation to minimize Social Security and Medicare taxes.

Bill Bischoff, a certified public accountant with more than 25 years of experience, has authored books and training courses for tax professionals, and frequently writes about consumer and small-business tax matters.