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  • Kevin Cleveland

Choice of Business Entities: A Primer

Selecting the right type of legal entity for your business requires careful consideration of many factors that may carry different weight, depending on your specific facts and circumstances. This article provides an overview of the most common types of business entities used today and draws comparisons among those entities based on a few select considerations with the broadest application. In other words, please do not rely on the information presented in this article alone to determine the “right” legal entity for you and your business. Consult with professionals about the legal, tax and insurance ramifications of your decision. Entire books are dedicated solely to this topic for good reason.

Alternatives to Forming a Legal Entity

A sole proprietorship is a business owned and operated by one individual. No separate legal entity means low formation costs other than filing a fictitious business name statement or “DBA”. Business income taxes are reported on the sole proprietor’s personal tax returns. Since there is no legal distinction between the business and the owner, however, the owner may be held personally liable for any claims against the business and the business will cease to exist upon the death or incapacity of the owner. Moreover, a sole proprietor cannot issue “equity” interests issue to attract employees or investors. For a one-person business that have limited liability exposure and do not need employees or investors, a sole proprietorship is an attractive option, particularly if the owner can purchase sufficient insurance to protect against liabilities of the business.

Joint ownershipis another alternative to forming a legal entity, commonly used for rental real properties held for investment. All of the advantages and disadvantages of a sole proprietorship also apply to joint ownership. Additionally, debts and liabilities of one joint owner may affect the interests of the remaining joint owners.

Common Types of Entities

Partnershipsrequire two or more persons (individuals or entities) to form. A general partnership requires less formalities than a limited partnership; in fact, a general partnership may be formed and operated without a written partnership agreement (although not recommended). In both types of partnerships, the general partners are subject to unlimited liability for (i) the partnership’s debts and liabilities and (ii) the other general partners’ tortious acts during the ordinary course of partnership business. The liability of the limited partners of a limited partnership is capped at the amount of his or her investment in the business unless the limited partners participate in controlling and managing the partnership. Both types of partnerships can be formed quickly and fairly inexpensively, and may serve as the ideal vehicle under the right circumstances. For example, two sole proprietors may come together form a general partnership if the combined business has no plans to seek outside investment and has limited liability exposure, especially with insurance coverage. Limited partnerships may be attractive for single-transaction or limited-term projects, especially if one or more limited partners will provide the capital and one or more general partners will manage the business. Overall, general and limited partnerships have fallen out of favor as limited liability companies (LLCs) and limited liability partnerships (LLPs) for certain professions have become increasingly common. In California, limited liability partnerships may only be formed by professionals practicing architecture, law, engineering, public accountancy, or land surveying.

A corporationis formed as its own separate legal entity under the laws of its domestic state by one or more owners/shareholders. All corporations initial form as C corporations which are subject to “double taxation”: the corporation is first taxed on its profits at the entity level, then the shareholders are taxed on any dividends distributed to them by the corporation. After formation, the corporation may elect to taxed under subchapter S of the Internal Revenue Code. An S corporation is a pass through entity not subject to double taxation, meaning that the profits and losses of the corporation pass through to the individual shareholders for reporting on their individual income tax returns. Double taxation versus pass through taxation is only one of many factors that must be considered when contemplating between a C corporation and an S corporation. Both are well-established entities that offer its shareholders an effective shield against personal liability; however, a corporation must typically observe and comply with statutory corporate formalities to keep that “corporate veil” intact. (Caveat: see below for discussion of “statutory close corporations.”) An S corporation is subject to a lot more restrictions than its C corporation counterpart, including but not limited to the following:

  1. only one class of stock allowed, meaning no preferred stock to attract outside investors

  1. shareholders must be (i) individuals who are U.S. citizens or residents, (ii) estates or (iii) certain eligible trusts

  1. numbers of shareholders cannot exceed 100

  1. tax year limited to calendar year

The pass through tax structure itself can be disadvantageous to the growth of an S corporation. Shareholders of an S corporation must pay tax on the pass through profits of the business, meaning an S corporation may have to distribute dividends to enable its shareholders to pay taxes instead of using those profits as working capital to further grow the business. This can cause friction among shareholders or between the shareholders and management. For start-ups that plan to seek outside investment, S corporation shares are less attractive to venture capitalists and angel investors who want qualified small business stock (QSBS) treatment under IRC Section 1202 for their investment, assuming all other requirements are met. (In-depth discussion of QSBS is better left for another day.) A corporation may elect to be treated as a statutory close corporation under the California Corporations Code if certain requirements are met and specific language appears in the corporation’s governing documents. This election allows the shareholders to operate and manage the corporation much like an active partnership, meaning that many of those corporate formalities that typically must be observed to keep the “corporate veil” intact are relaxed for statutory close corporations. An in-depth discussion of statutory close corporations is better left for another day, as well. A quick note: Depending on the context, a reference to a “close corporation” can mean either a “statutory close corporation” as discussed above or any privately-held company whose shares are not available for sale to the public.

A professional corporation is another subset of the corporate entity form, available to individuals in certain professions set forth by statute that require a license or certification from the state to practice in that state, such as attorneys, accountants, engineers, and physicians. The list of covered professions is extensive, detailed, and subject to change, so professionals seeking to incorporate their practice are strongly encouraged to obtain counsel beforehand.

Like a corporation, a limited liability company (LLC) is formed as its own separate legal entity under the laws of its domestic state by one or more owners/members. In some ways, an LLC encompasses the most appealing features of each of the entities discussed above: protection against personal liability even if the owner/member actively participates in the business, pass through tax treatment (or not, if desired), and no limits on eligibility of owners/members. The governing document, called the Operating Agreement, can be as simple or complex as needed to reflect how the members and managers agree to manage and operate the business, which can be run like a corporation, a partnership, or a sole proprietorship. Unless the LLC elects to operate like a corporation, the LLC need not observe the same kind of formalities as its corporate counterparts to retain its limited liability shield.

The LLC is easily the most flexible legal entity available, especially with respect to distributions, allocations, or management. However, this does not mean that the LLC is right for everyone. An LLC’s limited capital structure may make it difficult to attract outside investors or key employees and consultants. Like S corporations, QSBS treatment is not available for membership interests in an LLC. LLCs operating in California are subject to the annual gross receipts fee which ranges from $900 to $11,790 depending on the LLC’s annual gross receipts from California sources. LLCs may avoid this gross receipts fee by electing to be taxed as a C or S corporation; however, this adds a layer of complexity to the entity’s tax reporting requirements. Finally, businesses engaged in banking, insurance, or trust company services and individuals practicing in those professions described above for professional corporations are prohibited from forming LLCs altogether.

Final Thoughts

Whether you are thinking of starting up a new business or changing the structure of your existing business entity, be sure to consider all of the factors that should inform your decision and discuss them with the right professionals. This article alone is not sufficient for you to make an informed decision. I urge you to contact our office and seek professional input before you take action. Please contact me for a free initial consultation for your business needs.

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