Theta Law Firm, LLP | Differences between Types of Business Entities in California

Differences between Types of Business Entities in California

What kind of legal entity is right for your business? Should you form an LLC, a corporation, something else, or nothing at all? These are the questions that new business owners face. This is one of the most important decisions for any new business. The attorneys of Theta Law Firm are familiar with the formation, maintenance, and dissolution of various business entities in California. For advice on how to form your business or other legal questions relating to your business, please feel free to give us a call or send us an email.

This article discusses some of the advantages and disadvantages of a few of the more common legal entities that businesses can be formed into in California, including: corporation, limited liability company, limited liability partnership, limited partnership, general partnerships, and sole proprietorships. This article is no substitute for legal advice. If you're considering forming a business entity, speak with an attorney.

For a complete California Business Entity Comparison Chart, go to www.thetafirm.com/articles .

C Corporation

A C corporation (the common, general form of corporations) is probably the most well-known business entity form in the U.S. A corporation is an old, well-established, and common form of legal business entity created and regulated under state law. Corporations provide limited liability protection to its shareholders, who are collectively the owners of the corporation. In California, a corporation is managed by a board of directors, which makes the major business decisions and oversees its operation generally. The board of directors also appoints the corporations officers. The day-to-day operations of California corporations are handled by the corporation's officers.

Advantages of forming a C corporation:

Liability Protection: One of the primary benefits of forming a corporation (as opposed to operating a business in your name) is that the formation of a corporation generally protects its shareholders from liability. If your company gets sued, your personal assets (beyond your investment in the business) are protected.
Taxation Benefits: Forming a corporation allows you to take deductions for your corporation that (e.g., certain salaries, operating expenses, employee expenses, corporate equipment, insurance, travel, interest payments, professional services, taxes). However, see the taxation drawbacks discussed below.
Perpetual Existence: The corporate entity does not die, unless it is dissolved.
Shareholder Investment: Corporations can sell shares of ownership to build capital and to grow. C Corporations can also go public.
Enhanced Credibility: Whether justified or not, people often take your business more seriously if it is formed as a corporation.

Disadvantages of forming a C corporation:

Double Taxation: (1) Profits of a corporation are taxed (2) owners then pay additional taxes on their salaries and/or dividends. This is called "double taxation." The other business entity forms discussed here are not subject to double taxation.
Complicated Formalities: There are numerous requirements that corporations must comply with, including annual filings and actions that must be taken by the corporation's board. Tax laws are also complicated for corporations.
Required Disclosures: Substantial information needs to be disclosed to governmental entities and is then accessible to the public. California's Secretary of State website makes available information relating to all corporations, including the address of the business, as well as the name and address of the agent for service of process.

S Corporation

A California S corporation is just a corporation that elects to be treated as a pass-through entity for purposes of federal taxes. In other words, S corporations do not pay federal income taxes.

Advantages of forming an S corporation:

Liability Protection: As with C corporations, one of the primary benefits of forming an S corporation (as opposed to operating a business in your name) is that the formation of a corporation generally protects its shareholders from liability. If your company gets sued, your personal assets (beyond your investment in the business) are protected.
No Federal Income Tax for Corporation: S corporations do not have to pay federal income tax, so S corporations are not "double taxed" like C corporations are. However, just as with any business entity, individual owners do need to report income from salaries or their share of the S corporation's distribution of profits.
Self-Employment Tax Only On "Reasonable Salary": Not all of the profits of an S corporation are subject to the self-employment tax (Social Security and Medicare, which eats up about 15% of your income). Instead, S corporations only need to pay self-employment tax on the portion of the profit that is classified as a reasonable salary. For an LLC, however, all of the profit is subject to a self-employment tax.
Perpetual Existence: The corporate entity does not die, unless it is dissolved.
Shareholder Investment: S corporations can attract investment by selling shares of stock. However, the ability of S corporations to do this is very limited compared to C corporations. S corporations cannot go public.
Enhanced Credibility: Whether justified or not, people often take your business more seriously if it is formed as a corporation.

Disadvantages of forming an S corporation:

Strict Requirements for Formation: S corporations must meet certain requirements and observe certain restrictions that do not apply to C corporations. For example, C corporations cannot have more than 100 shareholders, they can only have one class of stock, they can only have certain kinds of shareholders (corporations and certain other entities cannot be shareholders in an S corporation), and so on.
Complicated Formalities: Just as with C corporations, S corporations have numerous formalities that they must perform on a regular basis, including various filings. This means that S corporations often have to hire lawyers and accountants to handle these issues.
Tax Obligations: In addition to the general corporate formalities that must be complied with, tax forms need to be filed properly in order to maintain S corporation status. The IRS pays closer attention to S corporation distributions to shareholders. In some cases, the IRS will recharacterize wages as dividends and vice versa.
Required Disclosures: Substantial information needs to be disclosed to governmental entities and is then accessible to the public. California's Secretary of State website makes available information relating to all corporations, including the address of the business, as well as the name and address of the agent for service of process.

California Statutory Close Corporation

The California Corporations Code allows for the creation of a statutory close corporation. Qualifying businesses can form a California close corporation to avoid some of the formalities applicable to California Corporations generally. Shareholders are given more direct control over the corporation. The reduced requirements for close corporations makes it harder for creditors to go after the personal assets of shareholders.

Advantages of Forming a California Statutory Close Corporation:

Shareholder Control: Close corporations can allow greater control by minority shareholders. Owners are generally provided greater latitude in operating their close corporation.
Flexible Distribution of Profits: Profits may be distributed disproportionately to share ownership (this may disqualify you from the ability to elect S corporation status).
Fewer Corporate Formalities: Corporate formalities can be dispensed with to the extent allowed for in the corporation's shareholders' agreements and by-laws.
Harder to Pierce Corporate Veil: It may be harder for third parties to "pierce the corporate veil" and go after your personal assets if you have a properly formed close corporation.

Disadvantages of Forming a California Statutory Close Corporation:

Formalities May Apply Anyway: You may need to follow some of the standard corporate formalities anyway because some third parties you do business with may require some of those formal documents to do business with you.
Shareholder Liability in Management: Shareholders who manage the business can still be liable for breach of fiduciary duties that are applicable to directors/officers of regular corporations.
More Expensive Formation: Forming a close corporation can be more expensive because it requires the creation of a shareholder's agreement.
Possible Loss of S Corporation Option: A California close corporation may not be able to elect S corporation status if it distributes profits disproportionately.
Less Attractive to Investors: Close corporations may be less attractive to investors because of the restrictions on transferring shares and the power of even minority shareholders to help manage the corporation.
Double Taxation: (1) Profits of a corporation are taxed (2) owners then pay additional taxes on their salaries and/or dividends. This is called "double taxation." The other business entity forms discussed here are not subject to double taxation.

Limited Liability Company

The California limited liability company is a relatively new form of legal business entity that provides for liability protection as well as pass-through tax status (if you elect it), without all of the complications of corporations. In other words, you get the best of both worlds: liability protection of a corporation and no payment of federal income taxes like a sole proprietorship, S corporation, etc. California limited liability companies are owned by their members. California LLCs can be managed by their members, or they can be managed by designated managers. The structure, maintenance, operation, and termination of LLCs is less complex than that of corporations.

Advantages of Forming a Limited Liability Company:

Liability Protection: As with corporations, one of the primary benefits of forming a limited liability company (as opposed to operating a business in your name) is that the formation of an LLC generally protects its owners from liability. If your company gets sued, your personal assets (beyond your investment in the business) are protected.
Taxation Benefits: If so elected, profits and losses are passed directly to the members. LLCs do not have to pay federal income tax (assuming the proper election is made), so they are not "double taxed" like C corporations are. However, just as with any business entity, individual owners do need to report income from salaries or their share of the LLC's income.
Informal Structure (less rigid) : LLCs do not have to comply with all of the strict formalities that corporations must comply with. The relationship between the members (owners) of an LLC is controlled by their customizable LLC Operating Agreement. For example, LLCs are not required to distribute profits based strictly on the ownership interest of each member like S corporations are required to do.
Enhanced Credibility: The formation of an LLC can give your business enhanced perceived credibility because it is a legally separate business entity (as opposed to a sole proprietorship).

Disadvantages of forming a Limited Liability Company:

California Annual Minimum Tax: LLCs in California generally must pay an annual minimum tax of $800/year, regardless of whether the LLC had any income that year.
LLC Law Is Relatively New: Unlike the law relating to corporations, the law relating to LLCs is relatively new and not completely defined. This creates some uncertainty for LLC owners.
Cannot Issue Stock: LLCs cannot by default issue stock in the way a corporation can. Selling ownership interests in an LLC is more complicated.
Self-Employment Tax: All profit is subject to a self-employment tax if you are actively involved in running the business (Social Security and Medicare, which eats up about 15% of your income). This is not the case for S corporations.
Required Disclosures: Substantial information needs to be disclosed to governmental entities and is then accessible to the public. California's Secretary of State website makes available information relating to all limited liability companies, including the address of the business, as well as the name and address of the agent for service of process.

Limited Liability Partnership

The California limited liability partnership, like a limited liability company, is also a relatively new form of business entity that provides for liability protection as well as pass-through tax status, without all of the complications of corporations. In other words, you get the best of both worlds: liability protection of a corporation and no payment of federal income taxes like a sole proprietorship, partnership, S corporation, etc.

Advantages of Forming a Limited Liability Partnership:

Liability Protection: Individual partners are protected from personal liability for negligent acts of other partners/employees not under their direct control. Moreover, LLPs protect the individual partners from personal responsibility for partnership debts and other obligations.
Taxation Benefits: Profits and losses are passed directly to the partners, based on their shares of ownership. LLPs do not have to pay federal income tax. However, just as with any business entity, individual partners do need to report income from salaries or their share of the LLP's income.
Equal Rights: By default, partners in an LLP can help manage the business (whereas in a limited partnership, the partners with limited liability cannot help manage the business).
Simplified Governance: LLPs are not as complicated to form and operate as other possible business entities.

Disadvantages of forming a Limited Liability Partnership:

Limited To Professionals: As of the date of this writing, the LLP is only available to certain licensed professionals (e.g. attorneys, accountants and architects).
California Annual Minimum Tax: Limited liability partnerships in California generally must pay an annual minimum tax of $800/year, regardless of whether the LLP had any income that year.
LLP Law Is Relatively New: Unlike the law relating to corporations, the law relating to limited liability companies is relatively new and not completely defined. This creates some uncertainty for the partners.
Self-Employment Tax: All profit is subject to a self-employment tax if you are actively involved in running the partnership (Social Security and Medicare, which eats up about 15% of your income).

Limited Partnership

The California limited partnership is a form of a partnership where there are general partners and limited partners. The general partner has management control, shares profits/losses of the partnership, has joint and several liability for the partnership's debts, and has the right to use partnership property. The limited partners have little or no control over the partnership's operation, but share a portion of the partnership's income/losses, so they are similar to shareholders in a corporation. Limited partners also enjoy some liability protection.

Advantages of Forming a Limited Liability Partnership:

Liability Protection For Limited Partners: A limited partner's liability is limited to the extent of their investment in the partnership.
Easier To Attract Investment: A limited partnership can attract investment because it is able to take investments from limited partners, while not forcing the general partners to give up management/control to the limited partners.
Taxation Benefits: Profits and losses are passed directly to the partners, based on their shares of ownership. LPs do not have to pay federal income tax. However, just as with any business entity, individual partners do need to report income from salaries or their share of the LP's income.
Harder To Pierce The Veil: Because there are fewer formalities involved in forming and maintaining a limited partnership, it is more difficult to "pierce the limited partnership veil" and go after a limited partner's personal assets. Limited partners just need to be careful not to comingle partnership funds/assets with their own.
Simplified Governance: LPs are not as complicated to form and maintain as corporations.

Disadvantages of forming a Limited Liability Partnership:

General Partners Are Not Protected: The general partners are liable for all of the partnership's debts and obligations.
Limited Partners Are Constrained: Limited partners cannot become involved in the daily management/operation of the business.
Self-Employment Tax: All profit is subject to a self-employment tax if you are actively involved in running the partnership (Social Security and Medicare, which eats up about 15% of your income).
Required Disclosures: Substantial information needs to be disclosed to governmental entities and is then accessible to the public. California's Secretary of State website makes available information relating to all limited partnerships including the address of the business, as well as the name and address of the agent for service of process.

General Partnership

Under California law, "partnership" means "an association of two or more persons to carry on as coowners of a business for profit formed under Section 16202." (See Cal. Corp. Code section 16101.) A partnership can be formed by operation of law, even where you and your partner don't have a written partnership agreement.

Advantages of Forming a General Partnership:

Easy Formation: A general partnership can be formed by operation of law (a written partnership agreement is not necessary). However, it is of course highly advisable to have a written partnership agreement.
Less Red Tape: Partnerships are subject to far fewer regulations than the other formal business entities described above.
Taxation Benefits: Profits and losses are passed directly to the partners, based on their shares of ownership. Moreover, general partnerships do not need to pay the same annual minimum tax in California that limited liability partnerships and limited liability companies need to pay. However, just as with any business entity, individual partners do need to report income from salaries or their share of the partnership's income.
Equal Rights: By default, partners in a general partnership can help manage the business (whereas in a limited partnership, the partners with limited liability cannot help manage the business).

Disadvantages of forming a General Partnership:

Unlimited Liability: Your personal assets are not protected if the general partnership is sued. Partnership creditors can go after the personal assets of the individual partners. Moreover, general partners can be jointly and individually liable for the actions of their partners (e.g., contracts entered into by another partner can bind the non-contracting partner).
Not Ideal For Investment: A general partnership is not designed to accept investment in the same way that a corporation is. While a corporation can sell shares to the public while still retaining control over its day-to-day operations, selling a percentage of a general partnership can lead to the loss of some control of the partnership.
Self-Employment Tax: All profit is subject to a self-employment tax if you are actively involved in running the partnership (Social Security and Medicare, which eats up about 15% of your income).

Sole Proprietorship

A sole proprietorship is a business entity owned and operated by a single individual. The sole proprietor receives all profits, is responsible for all taxes and liabilities of the business, and has total control over the business. There is no legal distinction between the business and the individual.

Advantages of Forming a Sole Proprietorship:

Taxation Benefits: Profits and losses are passed directly to the sole proprietor. Unlike a corporation, a sole proprietorship is not a separate entity for federal income tax purposes, so the sole proprietorship's income is not "double taxed" like that of a C corporation. However, just as with any business entity, the owner of the business does need to pay taxes as an individual.
Fewer Formalities: A sole proprietorship is not actually a separate legal entity, so there are no requirements for forming it. The only exception is that if you plan to operate under a fictitious name, you may need to register it with appropriate local governmental entity.
Comingling Of Assets: Sole proprietors also don't need to worry about comingling business and personal assets the same way that the owners of corporations and LLCs do.

Disadvantages of forming a Sole Proprietorship:

Unlimited Liability: Your personal assets are not protected if you (or your business, which is the same for legal purposes) are sued. Business creditors can go after the personal assets of the individual owner. You can be personally liable for a business-related accident where someone is injured or killed.
Not Ideal For Growth: In the eyes of the law, a sole proprietorship is not separate from the individual owner of the business. A sole proprietorship cannot sell shares of its ownership in the same way that a corporation can. An individual proprietor can, however, enter into partnership agreements with other individuals and/or take loans from outside entities to help fund the business.
Self-Employment Tax: All profit is subject to a self-employment tax if you are actively involved in running the partnership (Social Security and Medicare, which eats up about 15% of your income).