Choosing the Right Legal Structure for your Business in California – April 3, 2018

When you start or run a business, it’s vital to choose the right type of legal entity and structure.

It’s equally important to keep that structure under review as the right solution may change as time goes on.

No one entity is perfect for every business venture; there are a number of different factors that would favor the selection of one entity over another.

Choosing the right business structure can save you money and the pain of many headaches! There are several different legal structures under which you can choose to operate: sole proprietorship, partnership, limited liability company (LLC), S-corporation, C-corporation and non-profit corporation.

Each has advantages and disadvantages. Here I have given you an overview of the pros and cons of each. However remember this only highlights some of the key points. Make sure you get good advice before choosing the best option for you.

Option #1: Sole Proprietorship

A sole proprietorship is generally the simplest, most-common, least-regulated form of business and does not require any formal action to set up.

If you don’t incorporate and don’t have a partner, the law will automatically classify you as a sole proprietorship. To establish a sole proprietorship, all you have to do is obtain whatever licenses and permits are needed in your local area to begin operations.

One of the big attractions of this approach is the ease and speed of formation. You usually need to spend only a few minutes with your city or county clerk to obtain a business license or trade name certificate. Since no formal set up is required, reduced expenses come from not requiring legal help and additional registration fees with your state regulatory agency.

For income tax purposes, the government treats you and your sole proprietorship as one. An added tax saving comes about from not having to pay federal and state unemployment taxes on your profits.

One major disadvantage of the sole proprietorship is that you have unlimited personal liability in your business. This means that you are responsible for the full amount of business debts.

Option #2: Partnerships (technically known as the “general partnership”)

With the exception that a partnership has two or more owners, it is similar to a sole proprietorship in many ways. Creating a partnership can be very simple, since the law does not require any formal written documents or other formalities for most partnerships.

As a practical matter, however, it is a much sounder business practice for partners in a business to have a written partnership agreement that, at a minimum, spells out their agreement on such basic issues as how much will each partner contribute and how profits and losses will be divided among the partners.

Although the legal formalities to set up a partnership are greater than a sole proprietor, they are less when compared to the creation of a corporation. For income tax purposes, the profits or losses allocated (Schedule K-1) to you from a partnership are treated as ordinary income or losses.

However, a major risk inherent in a partnership agreement is that each partner can be held responsible for the debts, taxes, and other claims against the partnership. In addition, most state partnership laws provide that when one of the partners dies, quits, or declares bankruptcy, the partnership is then dissolved, jeopardizing the continuity of the business.

Another point o bear in mind is that a partnership is an understanding between partners. Much like a marriage, this understanding is nurtured by trust. Unfortunately, many partnerships end in a break-up.

Option #3: C-Corporations

An entity formed and operated as a corporation assumes a separate legal and tax life distinct from its shareholders. The label “C-corporation” merely refers to a regular, state-formed corporation. Corporations exist only because state statutory laws allow them to be created.

A corporation issues shares of its stock as evidence of ownership to the person or persons who contribute the money or business assets, which the corporation then uses to conduct its business. Thus, the stockholders (also known as shareholders) are the owners of the corporation, and they are entitled to any dividends the corporation pays.

Perhaps the biggest reason why many small-business owners incorporate their business is to limit their liability to the amount invested in the business – although there are certain exceptions to this.

Various lenders, including banks, venture capitalists, and others, are generally much more willing to make loans to a corporation that has been operating successfully than to a sole proprietorship or a partnership.

One of the big disadvantages of corporations is the corporate formalities required. A corporation can be created only by compliance with General Corporation Law of the state of incorporation. Getting this paperwork done takes time, effort and money.

Another potential disadvantage of a corporation is “double taxation.” The corporation pays tax once based on its corporate profits and a second time as ordinary income when profits are distributed to you as the shareholder. When your corporation loses money, such losses remain within the corporation and no immediate benefit is derived from the potential offset against earned income.

Option #4: S-Corporation

Many business owners hesitate to the double taxation rules imposed on C-corporations. Setting up your business as an S-corporation alleviates this “double taxation” rule.

An S-corporation begins its existence as a C-corporation upon filing the articles of incorporation with the secretary of state. After the C-corporation has been formed, it may elect “S-corporation status” by submitting the appropriate form to the Internal Revenue Service (in some cases a state filing is required as well).

Once a corporation makes the Subchapter S-election to be an S-corporation, profits and losses are passed through the corporation and are reported on the individual tax returns of the respective shareholders of the S-corporation.

To qualify, your business must meet the specific requirements set forth by the IRS.

There are several advantages of an S-corporation. For example, it receives limited liability protection accorded to corporations while avoiding the double-tax feature of taxation of your corporate profits. It also permits benefit of offsetting business losses incurred by the corporation against your income.

In an S-corporation, only earnings actually paid out to an owner as compensation for services are subject to payroll taxes. Any money distributed to the shareholder as a dividend is not subject to payroll taxes… and not subject to self-employment tax.

However, there are certain disadvantages of S-corporations. These include the corporate formalities: An S-corporation follows the same state formalities as a C-corporation and must also make a special tax election under the Internal Revenue Code.

S-corporations also offer less generous loss deductions compared to LLCs. Some states require all S-corporations to pay a minimum corporate tax regardless if the business reports a loss.

Option #5: Limited Liability Company (LLC)

An LLC is a business entity consisting of one or more “persons” (meaning an individual, general partnership, association, trust, estate or corporations) conducting business for any lawful purpose.

This form of business entity is a hybrid between a partnership and a corporation in that it combines the “pass-through” treatment of a partnership with the favorable limited liability accorded to corporate shareholders.

While an LLC has many of the same characteristics as an S-corporation or a limited partnership, it is, in many cases, more flexible.

With a few narrow exceptions, LLC members are not subject to the debts and obligations of the LLC and thus enjoy the same “limited liability” of a corporation. Should members of an LLC desire additional tax savings, it can elect to change its tax status to that of a regular corporation.

Disadvantages of an LLC include transferability of ownership. No one can become a member of an LLC (either by transfer of an existing membership or the issuance of a new one) without the consent of members having a majority in interest (excluding the person acquiring the membership interest) unless the articles of organization provide otherwise.

Other disadvantages include that an LLC does not have a reliable continuity of existence. The articles of organization must specify the date on which the LLC’s existence will terminate. Filing to form an LLC can be also extremely complicated, and the paperwork needs to be completed meticulously.

Option #6 Nonprofit Corporations

A nonprofit organization is a group organized for purposes other than generating profit and in which no part of the organization’s income is distributed to its members, directors, or officers.

Nonprofit organizations include churches, public schools, public charities, public clinics and hospitals, political organizations, legal aid societies, volunteer services organizations, labor unions, professional associations, research institutes, museums, and some governmental agencies.

Conclusion

It is reasonably well-accepted and understood that selecting the most appropriate entity is extremely important when you first get into business. The fact not clearly understood by most small-business owners is its significance when you are already in business.

For existing businesses, it is important to know that one type of entity selection may be more advantageous in one year but not in another, due to a shift in circumstances. I recommend that your accountant review the appropriateness of your entity at least once annually. An accountant well-versed in this area will provide excellent insight into which entity is right for you.

For more on this topic, please check out my book “Secrets of Small Business Success in the San Francisco Bay Area“.