What Business Entity Should You Choose?
You’ve decided to start your own business – congratulations! Whether this is a new full-time venture or a side hustle, you have an exciting journey ahead of you.
Operating a business comes with many challenges, rewards, and, most importantly, choices. Often times the first choice that a new business will encounter is what type of entity to use. There is no “one-size-fits-all” for choice of business entity—all entities have advantages and disadvantages depending on your industry, size, and ultimate business goals.
Do I Need To Form An Entity For My Business?
The primary reasons for creating a formal entity such as a limited liability company (LLC) or a corporation revolve around two important considerations: protecting your personal assets from creditors (i.e., limited liability protections) and tax treatment.
To determine whether you want limited liability protections for your business, ask yourself if your business involves the risk of owing money to another person. For example, could a customer could get hurt using your products or visiting your business (i.e., slip and fall), or could your business default on a loan from a bank or other lender? If the answer is “yes” to either or both of these, you likely will want some form of liability protection so that your personal assets are not at risk if your business is liable to another person or entity.
Sole proprietorships and general partnerships generally do not provide limited liability protections for their owners, whereas LLCs and corporations do.
What Entity Types Are Available?
The most common entity types of California business formation include:
Sole Proprietorship;
General Partnership;
Limited Liability Company (LLC);
C Corporation; and
S Corporation.
A basic overview of the limited liability protections and tax treatment of each entity type is discussed below.
What Is A Sole Proprietorship?
A Sole Proprietorship is a default entity that exists when a single owner begins a business. In California, LLCs and Corporations must file formation documents with the state (Articles of Organization for an LLC; Articles of Incorporation for a Corporation), but a Sole Proprietorship does not require formal paperwork.
Although a Sole Proprietorship has only one owner, the business can hire employees, freelancers, and consultants. However, the owner is the only one responsible for making the decisions for the business and all of the profits and losses will go to the owner. A Sole Proprietor will typically report profits and losses from their business on their personal tax returns.
What Is A General Partnership?
A General Partnership is a default entity that exists when two or more people start doing business with the intent to make a profit. The partners can be individuals or business entities, and like a Sole Proprietorship, no formal documentation is required to operate as a General Partnership. However, when beginning a business with any other parties, it is highly recommended to establish a written Partnership Agreement to clarify each partners’ responsibilities and how profits and losses are to be split among the partners.
General Partnership owners will file two returns: Form 1065, which is the General Partnership’s own informational tax return, and each Partner should report their portion of profits and/or losses on their personal tax returns.
What Is A Limited Liability Company (LLC)?
An LLC is an entity that is separate from its owners (also called Members), and therefore is responsible for its own debts and liabilities. The Members have no personal liability for the debts incurred by the business. Articles of Organization must be filed with the California Secretary of State to form an LLC and an Operating Agreement, which governs the operations of the LLC, should be created. Statements of Information must be filed within 90 days of formation, and then every two years thereafter to keep the LLC in good standing. Additionally, LLCs are subject to the California Franchise Tax Board’s minimum tax of $800. Special formalities must be followed in order to maintain the Members’ limited liability for the LLC’s debts. If these formalities are ignored, the liability protections will also be ignored and the Members’ personal assets become available to the LLC’s creditors.
By default, an LLC is treated as a “disregarded entity” for tax purposes. This means that the LLC is not taxed on its income, rather, all income will be reported on the Members’ individual income tax returns.
What Is A C Corporation?
Like an LLC, a C Corporation is an entity that is separate from its owners (also called Shareholders), and therefore is responsible for its own debts and liabilities. Articles of Incorporation must be filed with the California Secretary of State to form a C Corporation and Bylaws, which govern the operations of the C Corporation, should be created. A Statement of Information must be filed within 90 days of incorporation, and then annually thereafter to keep the C Corporation in good standing. Like an LLC, special formalities must be followed in order to maintain the Shareholders’ limited liability for the C Corporation’s debts.
The primary tax disadvantage of a C Corporation is that its income can be taxed twice: first at the corporate level when income is earned, and again at the Shareholder level when income is distributed to Shareholders as a dividend.
What Is An S Corporation?
An S Corporation is tax election rather than a separate entity type. First a C Corporation is formed with the state and then a Form 2553 election (also known as an S Election) is filed with the Internal Revenue Service. The S Election is only available to C Corporations that meet specific criteria. It is important to work with a qualified corporate attorney before filing an S Election to determine whether the S Election is beneficial to your business and whether your business will qualify for the S Election.
The S Election treats the C Corporation as a “disregarded entity” for tax purposes. Income is not taxed at the corporate level and the business’s profits and losses will pass through to the Shareholders’ individual income tax returns.
How Do I Form My Entity?
Of course, choosing which business entity is right for your company will heavily depend on your specific situation and goals, and should be discussed in greater detail with a qualified corporate attorney before making a final entity choice. To schedule a free consultation to find and form the right business entity for you, contact Brennan Law Office at (949) 329-2989 or e-mail Irvine corporate attorney Kayla M. Brennan directly at kayla@brennan-lawoffice.com.