Forming a Business Entity
At Bennett and Bennett, we take the time to work with business owners to help them decide which form of business entity to use and then properly and fully forming their organization. Our firm performs many business entity formations on a flat rate basis. For pricing, click here to review our competitive Flat Fee Pricing Model .
Business Entities Overview
There are numerous forms of business entities in California that protect the owner’s assets from business liability. Each of these entities is considered its own separate “legal person” with its own assets, liabilities, contracts, etc. If formed and governed properly, a business entity will protect the business owners’ personal property from business liabilities and also provide tax benefits as well. There are many different types of for-profit and non-profit business entities commonly used in California. The following is a brief summary of each type:
Sole Proprietorship and General Partnerships:
Many start-ups and other small businesses are owned directly by their founders in either a Sole Proprietorship (owning your business in your own name) or a General Partnership (basically a Sole Proprietorship between two or more people). The downside to these forms of business is that there is no liability protection. The owner’s personal assets are fully exposed to the liabilities of the business. So if your business is hit with a judgment, everything you own will be exposed to that judgment. For that reason, Bennett and Bennett strongly suggests that business owners not own their businesses directly and virtually never forms General Partnerships.
A Limited Partnership is a partnership that has one or more general partners and an unlimited number of limited partners. General partners have joint and several liability to all partnership debts and obligations. The general partner can be a corporation or a partnership. The general partners have responsibility for the day-to-day operations of the Limited Partnership and can bind the Limited Partnership contractually. On the other hand, the limited partners are passive investors with no right to manage the Limited Partnership and are generally not personally liable to third party creditors of the Limited Partnership. Limited Partnerships are often used when the parties desire flexibility in adding or removing passive investors and have a corporate general partner to whom they can delegate management. The downside to a Limited Partnership is that the general partner is personally liable.
Limited Liability Company (LLC):
Another common type of business entity in California is the Limited Liability Company (LLC). LLCs are frequently used to purchase and hold real estate. Bennett and Bennett forms basic LLCs on a flat fee basis. Click here to review our competitive LLC flat fee pricing.
An LLC is a hybrid between a partnership and a corporation. LLCs are available to most businesses, but not to certain professionals who are only allowed to practice their professions within a limited partnership or a professional corporation. A single member LLC is allowed, but generally not recommended because of the possibility of a bankruptcy trustee stepping into the member’s interests and selling the assets of the LLC. LLCs are generally taxed as a partnership and not as a separate entity. The benefits of an LLC are that the LLC protects its members from personal liability from the LLC’s debts. It is simple to add investors or other new members, members may agree to share profits and losses however they choose and there are limited formalities required to run an LLC, for example, there are no annual meetings required. The downside to running an LLC is the State of California double taxes LLCs on income over a certain amount. They call it a “surcharge”; however, the net effect is that the LLC can be double taxed and the sliding scale “surcharge” is taxed on gross receipts, not income.
By far the most common form of business entity in California is a corporation. Bennett and Bennett forms dozens of corporations per year on a flat fee basis. Click here to review our competitive incorporation flat fee pricing .
As with an LLC, the primary benefit to a corporation is that the corporation is a separate legal entity, so there is generally no stockholder personal liability for corporate debts. Stock in a corporation is not as easily transferred as a membership interest in an LLC or a limited partnership interest and must fit within the private placement exemptions under the SEC rules. As such it can be sometimes difficult and expensive to add investors after the corporation is formed.
A common misconception is that a “C corp.” and an “S corp.” are types of corporations. They are not. “C corp.” and “S corp.” simply designate how the corporation is to be taxed by the IRS. If the corporation is taxed independently, the corporation is called a “C corp.”. The term “C corp.” is derived from the Internal Revenue Code section governing this type of taxation.
Rather than having their corporation taxed as a separate entity, many business owners elect to have the corporation’s taxes passed through to the shareholders onto their personal tax returns. If the corporation is taxed in this manner, it is commonly called an “S corp.”. Again, an “S corp.” is not a separate type of corporation, but simply designates the Internal Revenue Code section under which this type of taxation occurs.
Frequently, business owners will desire to form their corporation in a state that does not have corporate income tax. However it’s important to note that any out-of-state corporation must register with the California Secretary of State if doing business in California. As such, there’s no real tax benefit to filing in Nevada, Delaware, Wyoming or any other state that does not have a corporate income tax if you are doing a substantial amount of business in California.
There are two basic types of for-profit corporations in California: the “Standard Corporation” and the “Close Corporation”.
The first type of corporation is what we call a “Standard Corporation”. A Standard Corporation is best in larger companies that require a formal management structure, flexibility in the number of shareholders and for a corporation that may desire to issue preferred stock to investors. Any corporation that plans to “go public” should be formed as a Standard Corporation.
The second type of corporation is what’s called a “Close Corporation” or sometimes a “Closely Held Corporation.” A Close Corporation is designed specifically for small businesses (frequently, family businesses). A Close Corporation has all the protection of a Standard Corporation and can be taxed either as a C corp. or an S corp.; however, a Close Corporation can elect to have an informal management structure and relaxed corporate formalities. The Close Corporation can elect to be run by a “manager” which is an individual who acts in all corporate capacities (shareholder, director and officer) without having to “change hats”. In other words, the Close Corporation can be run more like an LLC than a formal corporation.
There are numerous requirements for the formation of a Close Corporation that limits its applicability to small businesses. A Close Corporation has all the same organizational requirements as a Standard Corporation, plus it must have less than 35 shareholders, can only have one class of stock (i.e. it cannot issue preferred stock), must have an agreement with its shareholders which can waive the requirement to hold meetings, bypass the board of directors, provide for a disproportionate control or profit split and contain a buy sell agreement and the stock certificates must include a Close Corporation legend.
The primary benefit to having a Close Corporation, in addition to the informal management structure, is that a failure to observe certain corporate formalities will not be detrimental to the corporation. For example, a Close Corporation is not required to hold annual meetings, whereas a Standard Corporation is. The failure to observe corporate formalities, particularly the failure to hold meetings or keep minutes, cannot be considered in attempting to pierce the corporate veil of a Close Corporation. The downsides to a Close Corporation are the stock limitations which permits only one class of stock is to be issued and the requirement that there will always be less than 35 shareholders.
Non-Profit Corporations and Tax Exempt Status:
Frequently, business owners want to form a non-profit corporation for religious, philanthropic or tax purposes.There are many different types of non-profits, from those with an expressly religious purpose to sports leagues and homeowner’s associations. The formation of a non-profit corporation and obtaining tax-exempt status with the IRS and the California Franchise Tax Board can be a complex and daunting task. Not only is it necessary to properly form the corporation, it is likewise imperative that the tax exempt applications to the IRS and Franchise Tax Board be accurately and artfully stated. IRS Form 1023, which is the application for the IRS tax-exempt status, is extremely lengthy and complex. It is imperative that the individual preparing the application be very familiar with the tax-exempt application rules and the proper way to answer the IRS’ questions again to maximize the potential that the IRS will grant the tax-exempt status.