The limited liability corporation (LLC) form of business ownership has been gaining in popularity throughout the country. Do not think that this trend is limited to large corporations. For instance, a sole proprietor may choose to operate his or her business as a single-member limited liability company (SMLLC).

With an SMLLC, you are entitled to the same protection from personal liability as corporate owners using the LLC format. In other words, creditors generally cannot go after your home or your personal bank holdings. Only the SMLLC assets are exposed to this risk. Furthermore, you avoid the double taxation problem that applies to regular C corporations.

Background: To qualify as an SMLLC, you must observe all the legal formalities required by state law, including drafting articles of incorporation and filing them with the appropriate state agency. In a few states, you must also publish your intention to form an LLC in a newspaper.

Unless you elect otherwise, an SMLLC is treated as a “disregarded entity” that is not subject to double taxation. Like a partnership, all items of income and expense are reported on your personal return. Thus, you can realize the dual benefits of partnership taxation and personal liability protection.

In contrast, the earnings of C corporations are taxed twice—once on the corporate level and again on the personal level when you receive payment as dividends or compensation. This difference is often a key attraction for small-business owners.

Nevertheless, if it suits your purposes, you can elect to be taxed as a corporation by taking the appropriate action on your tax return. This might make sense if you intend to retain earnings that will eventually be paid out at a lower corporate tax rate than your regular personal tax rate. But most taxpayers with SMLLCs prefer partnership-type taxation.

If you operate an SMLLC and benefit from partnership-type taxation, you are required to pay self-employment tax on your earnings. For 2009, the self-employment tax is 12.4 percent on the first $106,800 of earned income (up from $102,000 for 2008). An additional 2.9 percent tax applies to all earned income. However, you are entitled to deduct half of the self-employment tax you must pay. 

State and local taxation is also a consideration for small-business owners. For example, in certain states, an annual franchise tax is levied on LLCs. In contrast, sole proprietorships may be exempt. Check with your tax advisor for the applicable law in your state.

Generally, making a switch from a sole proprietorship to an SMLLC is comparable with setting up an LLC for the first time. But there are complications if you decide to convert a C corporation to an SMLLC. Reason: The conversion is treated as a taxable liquidation of the corporation. Therefore, you will probably owe tax if your company owns appreciated assets, including intangibles such as goodwill.

In summary: This is not a do-it-yourself proposition. Rely on guidance from expert professional advisors.