Choosing the Right Business Entity
Building a business is exciting. However, it’s also stressful when trying to decide on the appropriate legal entity for your business. In California you have many different types of business entities to choose from. It is important to properly evaluate each type of business entity, since selecting the correct business entity from the beginning will save you both time and money in the long run.
Here’s a brief description of business entities you can choose from in California, with some pros and cons of each.
A sole proprietor is ran by one person for their own benefit. It is the simplest form of business organization and generally does not require very much to get started. Sole Proprietorships have no existence apart from the owner. To do business under a sole proprietorship, the owner should obtain a business license from the city where the business will operate. If the owner wants to do business under a formal business license, they must file a fictitious business name statement prior to obtaining a business license. A sole proprietor has no formalities and the owner has complete management authority. However, any liabilities associated with the business are the personal liabilities of the owner. There are no liability protections, therefore all personal assets can be at risk if the business fails. Also, the business terminates upon death of the proprietor.
If you are looking to form a general partnership you must have at least one other person as a partner and, depending on your conduct, you may already have since a partnership can be express or implied. A partnership is when two (or more) people come together for the purpose of carrying on a business venture for profit. Its formation is not dependent on any particular formalities and each partner has an equal right to participate in management and control of the business. Each partner: 1) contributes money, labor, or skill; 2) shares in the profits and losses of the business; and 3) is jointly and severally liable for the debts or obligations of the business. Death or withdrawal from a partnership causes a dissolution of the entire partnership. Although you don’t need to register with the state you can file a statement of Partnership Authority.
A Limited Partnership is a business entity that has a ‘general’ partner or partners that manage the business and who are personally liable for business debts. Limited Partnerships also have one or more ‘limited’ partners that contribute capital to the business but has minimal control over day to day operations. It is important to note that unlike a ‘general’ partnership the ‘limited’ partners are not personally liable for partnership obligations. Limited partners share in the profits and losses without actively participating in the business. Profits or losses pass through to the partners. Partnership survives the death or withdrawal from the partnership of a limited partner, but not of a general partner. Here, you do need to register with the state.
Limited Liability Partnership (LLP)
Limited Liability Partnerships have no “general” partners. All of the owners of a limited liability partnership have limited personal liability for business debts. A big advantage of an LLP is that the entity avoids double taxation because they are taxed as pass-through entities. In California, licensed CPA, lawyers and architects can form an LLP (however, come January 1, 2019, architects will be excluded). In order to form an LLP in California, an application to register a limited liability partnership must be filed with the state. Additionally, the partners should have a formal, written partnership agreement. Note that California also requires liability insurance.
Limited Liability Company (LLC)
Limited Liability Companies are a hybrid of a partnership and a corporation in that they combine the pass-through income treatment of a partnership with the limited liability of a corporate shareholder. LLCs provide protection from personal liability and are considered the most flexible business entity of the entities previously discussed. LLCs require you to file the Articles of Organization with the state. Additionally, you should also create a formal operating agreement. LLC’s do not issue stock and are not required to hold annual meetings or keep minutes. An LLC survives the death of its member(s), so long as the deceased have heirs and/or has and buyout provision in the operating agreement.
A California corporation (aka a “C Corp”) is a legal entity that is separate and distinct from its owners. This legal entity operates under state law, the scope of activity and name are restricted by its charter. If you are interested in started a C Corp you file articles of incorporation with the state to establish the corporation. C Corporations have the advantage of offering limited liability to stockholders. Additionally, a corporation survives the death of any shareholder or the transfer of stock. Another advantage of a corporation is the ability to raise capital due to multiple owners with a greater pool of resources. Selling shares of stock or creating and selling new classes of shares creates additional capital.
Most people realize that the big disadvantage of a C Corporation is the double taxation aspect. For example, taxes on profits and second via taxes on stockholder dividends (known as capital gains). Another big disadvantage of the C Corp is the formalities behind it. In order to avoid personal liability, corporate formalities must be followed, which include: election of a board of directors, appointment of officers, board meetings, corporate minutes, etc.
An S corporation is similar to a C Corporations in many respects, however the differences are notable. S Corporations are special closed corporations with limited shareholders and offer small corporations tax advantages (presuming you meet certain IRS Code requirements). S corps avoid “double taxation” because owners report on their personal income tax returns.
Professional Corporation (PC)
A professional corporation is a variation of the corporate form but only available to licensed professionals. Such professionals include doctors, chiropractors, lawyers, accountants, architects, etc. A professional corporation offers liability protection to professional service providers that would traditionally have structured their practices as sole proprietorships or partnerships. In a professional corporation, the owners perform services for the business as employees. A professional corporation have similar advantages and disadvantages associated with a corporation.
Nonprofit’s are a special type of corporation that meets specific tax-exempt purposes. Your Nonprofit must benefit: (1) the public, (2) a specific group of individuals, or (3) the membership of the Nonprofit. To receive federal tax-exempt status, the organization must apply with the IRS. The IRS identifies the different types of nonprofit organizations by the tax code by which they qualify for exempt status. One of the most common forms is 501(c)(3), which are organizations that do charitable, educational, scientific, religious and literary work.
At Hackler Flynn and Associates we work diligently with you to determine the best business entity for your needs. Please contact our office if you need assistance in determining the best entity for your business.