I receive a lot of calls on people wanting to start an new business but they are confused about the types of entities available to them to help insulate them from potential liability and exposure. This is a brief overview of the types of entities that can be used in California.
The most common business entities are: (1) Corporations; (2) Limited Liability Companies; (3) Limited Partnerships; (4) Partnerships; and (5) Sole Proprietorships (dba’s). It should go without saying that the selection of the proper form of business entity requires a careful analysis of numerous important factors, including tax considerations, compliance with required “corporate” formalities, potential personal liability/protection of personal assets, etc.
A corporation is a legal “person” that is separate from the people who own, control, and manage it. Effectively, this means that the corporation can enter into contracts, take on debt, and pay taxes apart from its owners. Consequently, with some exceptions, the owners of the corporation are personally protected from the corporation’s liabilities and creditors. In most instances, therefore, an owner only stands to lose what he or she invested in the corporation.
Corporations require state filings (e.g., Articles and Statement of Information). Additionally, state law mandates strict compliance with corporate formalities.
Corporations have two main divisions: (1) regular “C” corporations; and (2) “S” corporations.
“C” Corporation Characteristics:
-Taxed as a separate entity;
-Can’t deduct dividend payments to shareholders; and
-Can result in “double” taxation i.e., taxed at corporate level and again when dividends are distributed (doesn’t apply to close -corporations because shareholders are likely also employees – and thus revenues can be distributed to employees/shareholders as compensation and then deducted).
“S” Corporation Characteristics:
-Pass through taxation (no double taxation);
-Taxed as a partnership;
-Limited to domestic corporations with 100 or fewer shareholders (all citizens or legal residents);
-One class of stock;
-May not hold more than 80% voting power of another corporate stock (with some exceptions);
-May not allocate among shareholders or make disproportionate distributions.
LIMITED LIABILITY COMPANIES (“LLC”)
Limited Liability Companies (“LLC”) are created by statute, and thus must be organized under relevant statutory provisions (Articles of Organization). LLC’s combine limited liability protection for all equity owners without sacrificing any owner participation and/or management rights. Statute contemplates, but does not require, the creation of an Operating Agreement and other documents to control operation and management of LLC. Management can take many forms: from direct management by members, to decentralized management via delegation to one or more “appointed” managers (i.e. “managing member”) who have responsibilities to manage the LLC.
-No personal liability for debts or obligations of LLC;
-Member’s liability to the LLC itself is limited to the extent of any unpaid capital contributions;
-May have one or more members;
-Continues upon death if other members exist and nothing in papers state otherwise;
-Less complicated corporate formalities; and
-Can be treated like partnership for tax purposes (major advantage over “C” and “S” corporations).
-Must follow some corporate formalities to be eligible for protections offered, and
-Certain professions cannot form LLCs (B&P “professions” like law, medical, construction, accounting, etc.).
Additional advantages to the LLC:
-Some pass through taxation as “S” corporations, without the same amount of corporate formalities, and
-No limitations on numbers of shareholders, etc. (no requirement to call and conduct annual meetings to elect directors and officers, etc.).
Additional disadvantages to the LLC:
-No “fringe” benefits (i.e. no tax free life insurance or medical benefits);
-Restrictions to qualified retirement plans (in other words, no borrowing); and
-Higher marginal tax rates.
To create a limited partnership you must file a certificate with the state. The characteristics of a limited partnership are:
-Must be organized under relevant statutory provisions;
-Must strictly comply with corporate formalities; and
-Must consist of one or more “general partners” (“GPs”) and one or more “limited partners” (“LPs”):
-General partners have same rights of control and legal exposure as general partners of a General Partnership;
-Limited partners, however, are passive investors who provide cash/assets for use in the running of the business, and therefore an limited partners legal liability is restricted to the amount of their investment in the business; and
-Limited partners have few rights to exercise any control over day to day business; and
-Interests of limited partners are freely transferable and death, withdrawal, etc. has no effect on the limited partnership.
-For GPs, use of money/assets to get business going without having to give up power or decision making to investors; and
-For LPs, ability to share in profits of a business without having to run it.
-For GPs, same as General Partnerships; and
-For LPs, no control over how money is spent, etc.
General partnerships are essentially a sole proprietorship, but with more than one owner. They may be created by oral agreement (NOT a good idea) and/or inferred from conduct. New general partners cannot be added without unanimous consent. All partners owe a fiduciary duty to each other and unless otherwise agreed in writing, will the partnership will terminate upon death of one of the partners. All owners may manage the partnership equally.
Partners are jointly and severally liable for all debts and obligations, including torts committed by owner’s “agents.”
-No added formalities (other than those required by law, i.e. permits, dba, etc.);
-May have written agreements that spell out rights, limitations, and duties – open to limits of creativity;
-Not a taxable entity (pass through); and
-Losses may offset other income (same with sole proprietorship).
-Same as sole proprietorship – except now you have to deal with additional people.
SOLE PROPRIETORSHIPS (dba’s)
The typical sole proprietorship is a business entity with one owner. The owner manages all business decisions and is relatively uncomplicated to run. However, a sole proprietorship offers no protection from personal liability. Additionally, any conduct by the sole proprietor (or an employee) may expose the sole proprietor to personal liability. Lastly, the profits or losses from the business are reported on the owner’s personal tax return.
Other characteristics include, without limitation:
-It is the simplest form of business enterprise;
-Subject to minimal regulation;
-”Proprietor” owns all the assets of the business;
-Absolute control over management of business;
-Retains all profits of business;
-May enter into contracts;
-Terminates upon death or sale of underlying assets
- A proprietor is personally liable for all debts and obligations, including torts committed by owner’s “agents.”
- Complete control;
- Simpler; and
- No added formalities (other than those required by law, i.e. permits, dba, etc.).
-Personal liability (not necessarily a bad thing, especially if you have sufficient insurance or engage in a business where it is unlikely that any personal liability can result);
-Responsible for conduct of others; and
-Denied certain tax benefits (nonequal retirements plans, medical and dental plans