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Co-authored by Bryan Springmeyer |
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Starting a New Business - Choosing an Entity
Decisions about what entity to use for a business are multifaceted. Factors to consider include liability protection, state and federal taxation laws, management goals, ownership structure, investment/funding considerations, and exit strategies, among others. Prudent planning early on can eliminate the need to restructure later, which can be an expensive and timely process.
Below is a roundup of available business entities in California. To avoid getting too in the weeds, I’ve clustered some entities together and am just highlighting certain key features. Even if you know which entity is standard for your industry (most of our clients use C-Corps), it can be helpful to understand the range of options.
Sole Proprietorships and General Partnerships
- Common law entities with no required state filings.
- Unlimited liability. (Check out Bryan’s post on understanding founder liability).
- Examples:
- Sole Proprietor: If you sell lemonade and someone gets sick from drinking it or if someone sues you for breaching your contract to fulfill a bulk lemonade order, you would be personally liable for the full amount of the judgment meaning your personal assets are on the line.
- General Partners: If you agreed to share profits and control of the lemonade business with a friend, you’ve created a de facto general partnership. The partners would be jointly and severally liable for partnership debts, meaning each person is liable for the full amount of the partnership debts until they are fully paid off.
- Pass Through Taxation (pay taxes via your personal income tax return).
Limited Partnership
- Creating and maintaining an LP requires filing with California Secretary of State, having a detailed partnership agreement, and holding annual meetings. LPs are subject to California franchise tax (minimum $800 per year at the end of the fiscal year).
- Two Tiers of Partners, Two Tiers of Liability: General partners are responsible for management of the business and Limited partners are usually passive investors. General partners have unlimited liability and limited partners have liability limited up to the amount of their investment in the LP.
- Pass through taxation.
Limited Liability Partnership (LLP)
- In California, LLPs are only for lawyers, accountants, and architects.
- All partners share in liability for the partnership’s debts, but each partner is protected individually from liability arising from another partner’s misconduct. A partner who engages in misconduct like fraud or negligence will be personally liable for that misconduct.
- Pass Through Taxation.
Limited Liability Company (LLC)
- State Filing required and subject to the State Franchise Tax (minimum $800 per year at the end of the first quarter).
- Highly flexible, broad latitude to create customized structures and ownership arrangements.
- Limited Liability for owners (“members”), similar to limited liability for Corporations.
- Pass Through Taxation by default, but may elect to be taxed like a C-Corporation.
C-Corporation
- State Filing required and subject to the State Franchise Tax (minimum $800 per year).
- Other key requirements include adequate capitalization, recordkeeping, holding annual meetings, and keeping personal and corporate assets separate
- Shareholders and managers have limited liability for the corporation’s debts (i.e. only the business assets are subject to satisfying the company debts, not the personal assets of the principals). However, limited liability is not airtight. A court may “pierce the corporate veil” when formalities are not observed, when there is fraud or misconduct, or when limiting liability would result in a creditor assuming an unjust cost.
- Ability to issue stock. Having conventional instruments for issuing equity is one of several reasons why the C-corp appeals to investors. [More on why investors prefer C-Corps].
- Taxed as an entity, and then shareholders are also taxed when they receive any dividends or distributions. Historically, this was unappealing, but the 2018 tax law changes have almost removed the disparity in aggregate taxation resulting from double taxation. This calculator helps demonstrate.
S-Corporation
- The shareholders of a corporation may elect to be taxed under subchapter S at the federal level, which allows pass through taxation. To qualify to make the election, the Corporation must be closely held (no more than 100 shareholders), it may not have any nonresident taxpayer or corporate shareholders, and must meet certain other IRS eligibility criteria.
Corporate entity variations for companies committed to social impact and/or environmental sustainability include Benefit Corporations and Social Purpose Corporations. I will discuss these entities and other considerations for social enterprises in a future post.
Stay tuned.
Related Articles: Do I Really Need Limited Liability? |