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Business Types

The following is a brief summary of each of the various entity choices for a operating a business in California:

Make sure you check with a lawyer as you consider the proper solution for your particular case. This was put together on Jan 2007 for a California business (us) as we were deciding to change from a general partnership to an s corporation. Things always change. Make sure you get the most current information you can.

Things you should ask yourself:

How many principles are involved?
How concerned am I about personal liability?
How much money do I plan to gross & how much do I plan to make?
How much am I willing to spend on infrastructure?
What type of business am I in?
Will I have employees or contractors?

Take your thoughts on these and consult with a qualified CPA & Lawyer.

Sole Proprietorship

Description: A manner in which an individual engages in business personally rather than by means of one of the entities set forth below. This method avoids many of the formalities and reporting requirements associated with other forms of business organization. However, the proprietor is personally liable for the obligations of the business, which is usually the primary reason an individual might not use this option.

Our Take: Simplest, cheapest option for a single person. The issue of personal liability should be seriously considered based upon your type of business.

Corporation (Subchapter C)

Description: An entity which allows for limited liability in that none of the owners (i.e. shareholders) is liable for the corporation’s obligations merely by reason of being a shareholder. Formed under California law and governed by the Corporations Code. Income of the corporation is separately taxable at federal and state levels. Subchapter C refers to the section of the Internal Revenue Code governing taxation of corporations. Note that C corporations are subject to “double taxation” because the corporation pays taxes on its income and is not allowed to deduct as an expense dividends issued to shareholders, who then pay tax on such dividends. Double taxation is typically minimized by the payment of salaries (which must be reasonable) to shareholders, and the use of shareholder loans. Many corporations eliminate the double taxation problem by electing to be taxed under Subchapter S of the Internal Revenue Code (Subchapter S Corps). This Subchapter C tax structure is advised generally for businesses which reinvest most of their income.

Process: File articles of incorporation with the Secretary of Sate ($115.00), issue stock; shareholders elect directors, and officers are appointed by directors. Bylaws should be prepared and adopted, and it is advisable for shareholders to execute a buy-sell agreement outlining what may occur should one shareholder die, divorce or become disabled. Shares of stock in a corporation are the most easily transferable ownership interests of the interests under discussion, which is important if future sale of the business is contemplated.

Our Take: Ideal for larger companies that keep the money within the company rather than paying it to the owners. If I understand correctly, they also have a fixed tax rate of 36%, rather than a sliding scale (please double check this).

Corporation (Subchapter S)

Description: These corporations are the same entities as described above for purposes of California Corporations Law, but have elected to be taxed under Subchapter S of the Internal Revenue Code. A corporation making a valid S corporation election is taxed similarly to a partnership. The corporation’s net profits, losses and tax credits are passed through and taxed for federal tax purposes to the corporation’s shareholders and not the corporation, although California has a minimum tax of $800 per year for all corporations. California also has a separate tax for Subchapter S corporations which is 1.5% of corporate net income.

Process: Same as above, except that a Subchapter S election must be made by the shareholders and filed with the IRS within 75 days of date of incorporation if such tax treatment is desired for the opening tax year (otherwise can elect the following year for that tax year).

Liability: Corporate shareholders, directors and officers are ordinarily not liable for the debts or other obligations of a corporation. As a separate legal entity, the corporation itself is liable for such obligations.

Individuals may be held liable:

  • to the extent they have personally guaranteed corporate debts (often required by entities making loans to corporations)
  • to the extent they have received improper distributions (e.g., payments which might be characterized by the shareholders as dividends rather than employment income subject to employment taxes)
  • if a court “pierces the corporate veil” of a corporation to impose personal liability on shareholders (e.g where the shareholders failed to file corporate formalities such as maintaining filings, or keeping minutes of annual meetings).
  • if a director, officer or controlling shareholder breaches a duty to the other shareholders, or participates in tortious conduct

General Partnership

Description: An association of two or more persons to carry on as co-owners of a business. A partnership is an entity distinct from the partners. Each partner is an agent of the partnership and can bind the partnership in its ordinary course of business. Each partner is personally liable for the obligations of the partnership. For tax purposes, the income and losses flow through to the partners, who recognize gain or loss on their individual returns. A partnership files federal and state returns for informational purposes but does not pay tax. A K-1 is issued by the partnership to the partners indicating the gain or loss to flow through and this is reported on their individual returns. A general partner’s share of income is typically self-employment income subject to self-employment tax. (A Sub-S shareholder’s share of income is not taxed as self-employment income, though LLC member’s share of income is generally so taxed.)

Formation: One can maintain a general partnership on an oral basis, but it is advisable for the partners to enter into a written agreement outlining the terms and conditions of their business association as the California general partnership statute provides only as skeletal framework for the operation of a partnership.

Liability: Partners are jointly and severally liable for the wrongful acts or omissions of any partner acting in the ordinary course of partnership business or with authority of the partners, and jointly liable for all other debts and obligations of the partnership.

Our Take: Just like a Sole Prop but has 2 or more people. Make sure you have a clear set of written rules on how things work and what happens if it falls apart. Nothing can ruin a relationship like a failing business you weren’t prepared to handle.

Limited Liability Company (LLC)

Description: A form of business association which is not a corporation but whose members do not have personal liability for the debts of the LLC. An LLC is governed by specific provisions of the California Corporations Code. It is taxed similarly to a partnership, although in California it must pay a minimum tax of $800 per year as a corporation must, as well as a separate statutory fee for any year in which it’s gross revenues exceed a certain amount ($250,000.00). An LLC may elect to be taxed as a corporation for state and federal purposes.

Formation: File a Form LLC-1 (articles of organization) with the Secretary of State; fee is $85). All members will enter into an operating agreement which could be oral, but more practically, is generally written and addresses the terms and conditions of the business association. LLCs are relatively new form of entity and there is not a well developed body of case law regarding LLCs, thus it is not clear how LLCs will be treated under various circumstances. They are used most often for shorter-term ventures where liability protection is desired, or with respect to narrow ventures such as ownership of a particular piece of property by several members.

Liability: Members of the LLC are not personally liable for the debts, obligations or liabilities of the LLC. However members may be liable in situations similar to those set forth above with respect to corporations.

Our Take: There isn’t a lot of case law yet on LLCs and as a result things are not as clear. All I know, if you gross over 250k, you pay a heft fee, so if that at all possible, keep that in mind.