Choosing the right entity structure for your new business is an important early decision, because each type of business entity serves a distinctive set of needs. The choice usually hinges on two basic considerations: general concerns about the formation and structure of the entity, and tax concerns. Other important factors that should weigh on business formation strategy include local government regulations, as well as issues related to intellectual property.
List of entities (each linked to the material listed below, in its section):
- Sole Proprietorship
- C Corporation
- S Corporation
- Limited Liability Company
- General Partnership
- Limited Partnership
- Limited Liability Partnership
- Professional Corporations
Sole Proprietorships (“SPs”) are an extremely simple means of conducting business. SPs are known for their informality. An SP is not considered a separate business entity, and many of its rules are common-sense. Although limited by strict ownership requirements and liability rules, SPs remain a sensible business solution, particularly for many small business owners.
By definition, an SP may only have one owner, who is known as the Sole Proprietor. This person has sole control over the entity, and is personally liable for the debts of the business. The Sole Proprietor’s interest in the entity is freely transferrable.
Under both the Federal and California tax schemas, an SP business is taxed by simply taxing the owner’s net profits as individual personal income. There are no restrictions on the number of deductions of losses that the Sole Proprietor can claim, although amounts withdrawn for salary and personal use are not considered deductions. For tax purposes, the sale of either an SP business or its assets is treated as the sale of the Sole Proprietor’s individual assets.
C Corporations (“C Corps”) are the oldest and most conventional form of limited liability business entity. C Corps operate within a relatively formalized environment, and they utilize the well-defined roles of shareholders, directors, and officers. If the eventual goal of a business is to “go public,” a C Corp may be the most well-situated entity for that transition.
For a C Corp to be treated as such under the law, it must maintain ongoing corporate formalities, as well as abide by its Articles of Incorporation, bylaws, and any buy-sell agreements.
The owners of a C Corp are known as Shareholders. A Shareholder’s liability is limited to the capital he or she has invested. There are no inherent restrictions on the number of Shareholders, who may be organized into multiple classes. C Corps are governed by a traditional formula: Shareholders vote for Directors, who then elect Officers, who in turn operate the business.
It is often said that C Corps are subject to “double taxation.” This is a reference to the practice of taxing income and deductions at the corporate level, and then taxing dividends on the Shareholder level. Both the IRS and California Tax Franchise Board (“CTFB”) use this approach, with California also setting a minimum franchise tax of $800.
For tax purposes, the sale of C Corp business assets results in a corporate level gain. However if the entire C Corp entity is sold, the Shareholders are taxed on their capital gains instead. A C Corp’s losses are treated as the losses of the entity, so Shareholders cannot include such losses as deductions.
S Corporations (“S Corps”) are a relatively new form of corporate business entity that is similar to C Corps. S Corps have some tax advantages over C Corps, but are also constrained by a number of ownership restrictions.
Like C Corps, S Corps must maintain ongoing corporate formalities, as well as abide by their Articles of Incorporation, bylaws, and any buy-sell agreements.
As a structural matter, S Corps resemble C Corps in a number of ways. Both are owned by Shareholders, whose liability is limited to only the capital they have invested. Furthermore, each is governed by the same mechanism, in which Shareholders vote for Directors, which then elect Officers, who then run the business.
Despite all these similarities, S Corps are differentiated from C Corp in a number of ways, many of which relate to ownership restrictions. S Corps may only have between one and 100 Shareholders. Each Shareholder must be a U.S. Citizen or legal resident, although certain Trusts or Corporations may also be permitted to own shares. There may be no more than one class of stock in an S Corp. In addition to ownership restrictions, S Corps are also differentiated in other ways, such as the fact that certain financial institutions, insurance companies and domestic international sales corporations are not permitted to form as S Corps.
The major advantage that S Corps have over C Corps is that they can avoid “double taxation” by passing their corporate income and losses through to their Shareholders. Each Shareholder reports the S Corp’s income and losses on their personal tax returns, which are then taxed at their individual income tax rate. Thus the sale of an S Corp’s assets does not generally result in a corporate level tax gain, and Shareholders may deduct losses to the extent of their level of ownership interest.
If an entity files with the IRS as an S Corp, the California Tax Franchise Board (“CTFB”) will treat them as such. The CTFB also imposes the greater of either $800, or a 1.5% franchise tax on net taxable income.
Limited Liability Company
Limited Liability Companies (“LLCs”) can be thought of as customizable corporations. Rather than relying on traditional corporate structures and formalities, LLCs offer their creators an opportunity to structure the respective rights and responsibilities of owners and managers in a broader variety of ways.
Depending on the terms of the operating agreement, an LLC may be operated with fewer ongoing formalities than a C Corp or S Corp. For example, unlike a corporation, running an LLC does not automatically require that a Board of Directors hold formal meetings, produce minutes of those meetings, or adopt formal resolutions.
LLCs are owned by their Members whose liability is limited to the capital they invest. An LLC may either be “Member-Managed” or “Manager-Managed.” In a Member-Managed LLC, the Members both own and run the business, much like Partners. By contrast, Manager-Managed LLCs are more like corporations; the Members delegate responsibility to Managers, and are thus more reminiscent of Shareholders. There are no inherent ownership restrictions with LLCs, other than that a professional license may not be required to be an owner. LLCs can be structured with multiple classes of owners.
For tax purposes, an LLC may sometimes be treated as a corporation, as a partnership, or as part of the owner’s tax return. This will depend both on the number of owners and on the forms that the owner/s elect to file. In some LLCs, owners may deduct losses to the extent of their ownership in interest. The sale of business assets is taxed to the owners, with each owner’s tax liability limited to the extent of their business interest.
California imposes an $800 annual tax on LLCs, as well as an additional franchise fee based upon the amount of an LLC’s income that exceeds $250,000.
A General Partnership (“GP”) can be thought of as a group form of a Sole Proprietorship. Like SPs, GPs do not offer limited liability, but can be extremely simple and informal. The GP imposes traditional legal norms, such as fiduciary obligations, to govern its Partners.
Every GP must have at least two General Partners; every General Partner owns part of the business, and each is jointly and severally liable for the debts of the business. General Partners contribute money, property, labor or special skills, and they share in the profits and losses from the business. Furthermore, unless there is a Partnership Agreement which states otherwise, every General Partner manages the GP.
A GP’s income and expenses flow through to its owners, and are included on their returns. Owners may deduct losses to the extent of their ownership interest. The sale of business assets is taxed to the owners, with each owner’s tax liability limited to the extent of their business interest.
A Limited Partnership (“LP”) is essentially a GP that includes a separate class of partners with limited liability. LPs are employed when it is anticipated that one or more persons or entities will wish to invest in the partnership, but will not wish to participate in managing the business.
As with GPs, LPs are operated by one or more General Partners, who are jointly and severally liable for the debts of the partnership. Unlike GPs, LPs also include Limited Partners, whose liability is limited to the capital they invest. However, if a Limited Partner participates in the management of the business, courts may treat him or her as a General Partner, resulting in loss of limited liability protection.
There are no ownership restrictions in an LP, and multiple classes of ownership are by definition a part of every LP’s structure. An interest in an LP is generally transferrable, although the transferee’s rights depend upon the consent of the General Partners. A buy-sell agreement may be enacted to govern the rules regarding succession, disability, divorce or departure.
An LP’s income and expenses flow through to its owners, and are included on their returns. Owners may deduct losses to the extent of their ownership interest. The sale of business assets is taxed to the owners, with each owner’s tax liability limited to the extent of their business interest. In California, there is an annual franchise tax of $800 for each LP.
Limited Liability Partnership
Limited Liability Partnerships (“LLPs”) are the professional license holder’s answer to the LLC. LLPs allow lawyers, public accountants and architects to form flexible, partnership-style business entities, while still maintaining a degree of limited liability. The caveat is that every Partnermust hold one of these licenses. LLPs are also required to either exceed a certain net worth, or to maintain a minimum amount of insurance.
LLPs are operated by one or more General Partners who are jointly and severally liable for the debts of the partnership. LLPs also include Limited Partners, whose liability is limited to the capital they invest. A Limited Partner who takes an active role in managing the business risks being treated as a General Partner by the courts.
Every LLP must be owned by at least two partners, and every partner must be a lawyer, public accountant or architect (depending on the nature of the business.) As with LLCs, there are a great variety of potential control and management structures, although only General Partners may manage the business. A buy-sell agreement may be enacted to govern the rules regarding succession, disability, divorce or departure. In the absence of a Partnership Agreement and/or buy-sell agreement, each LLP is governed by default statutory rules.
LLPs must abide by the Revised Uniform Partnership Act, as well as any Partnership Agreements and/or buy-sell agreements. They must also comply with the relevant rules of any applicable professional governing organization. LLPs are often required to maintain a malpractice liability insurance policy against claims of at least $500,000, or of $100,000 per licensed practitioner, whichever is greater. An LLP may only avoid this requirement by certifying, in writing, that in the previous fiscal year it had a net worth or at least $10 million (if the business provides accounting or architectural services), or at least $15 million (if it provides legal services).
An LLP’s income and expenses flow through to its owners, and are included on their returns. Owners may deduct losses to the extent of their ownership interest. The sale of business assets is taxed to the owners, with each owner’s tax liability limited to the extent of their business interest. In California, there is an annual franchise tax of $800 for each LLP.
In California, certain professions are prohibited from forming a limited liability company or a traditional corporation and instead must incorporate as a professional corporation. Professions that are required to be professional corporations include many of those that must have a state license, such as dentists, certified public accountants, doctors, lawyers, optometrists, psychiatrists, and psychologists.
Professional corporations have more restrictions than traditional corporations. For example, with a few limited exceptions, officers, directors and shareholders of a professional corporation must be licensed to condu ct the professional activity.
In addition to specified rules governing professional corporations in the California Business and Professions Code, a professional corporation is also subject to the regulations of the applicable governmental agency overseeing the profession in which the professional corporation is engaged.
While professional corporations do not provide liability protection for malpractice, you could have limited liability protection for claims not based on malpractice, such as a slip and fall accidents.
By forming a professional corporation you may be able to deduct payments for benefit plans, such as disability or health plans or group term insurance. There could also be a potential for tax savings by forming a professional corporation and then electing to have it taxed as an S corporation, as it is eligible for an S election.