What is the best way to set up a small business with my spouse and I as primary owners?

First, there is relatively little to choose from between a limited liability company and a sub-chapter S corp. in terms of tax impact and protection from liability. Conventional wisdom at present favors the LLC because it has slightly less reporting and paperwork requirements than a sub-S and also alllows more flexibility in apportionging ownership and separating ownership and control:

1) With a sub-S, ownership is directly proportionate to monetary investment, but with an LLC, you can more easily value "sweat equity," if that's a consideration.

2) With a sub-S, any profits and losses are distributed in proportion to ownership, but with an LLC, you can specify in the operating agreement what the distribution should be.

That said, either an LLC or sub-S will do the job.

Second, your children: if your children are adults, you can right now make them part owners, especially of an LLC (see above), but restrict their profit participation and their management role unless and until something happens to you and your wife (or you change things by writing). With a sub-S, you could similarly make them minority owners. In either event, your will would then pass your ownership on to them, though again, with an LLC, there's a bit more flexibility in having a succession plan built right into the operating agreement.

With minor children, you'd probably need to set up a testamentary trust (which you'd need to do anyway, for any other property they inherit) and designate a trustee to manage the business for them in some capacity.

The best way to accomplish this is to sit down with a business attorney, describe the business and your needs in detail, and let him or her guide you through setting up a structure. Good luck.