CHOOSING A BUSINESS ENTITY STEVEN E. SPRINGER
When you are starting a business, one of the most important things to think about is how to organize the business. Depending on issues such as liability protection, tax laws, organization structure, and your investment needs, different business entities may be appropriate, and you can select an entity that is best suited to your needs.
GENERAL PARTNERSHIP OR SOLE PROPRIETORSHIP
A sole proprietorship or general partnership is a relatively informal business structure that does not require filing with the state.
The proprietor or partners have unlimited liability. This means that if the company owes a debt, such as from a lawsuit, and the company lacks sufficient funds to pay the debt, the partners may be personally liable. The creditor thus can collect from the partners’ personal assets.
General partnerships have pass through taxation, which means that the entity does not pay taxes on its income. Instead, taxes are paid only on the individual income tax return.
LIMITED PARTNERSHIP (LP)
Limited partnerships require a filing with the state, a partnership agreement, and annual meetings. LPs are subject to California’s franchise tax.
LPs have two levels of partners: the general partner, who has unlimited personal liability, and limited partners, who are only liable up to the amount of their investment. Sometimes, the general partner is another entity, such as an LLC. Often, the general partner or partners are responsible for running the business, while the limited partners are passive investors.
LPs use pass-through taxation, so no income tax is paid on the entity level.
LIMITED LIABILITY PARTNERSHIP (LLP)
In California, limited liability partnerships are only available for professionals, such as lawyers, accountants, and architects. All partners in an LLP are personally liable for the partnership’s debts. However, no partner is liable for debts arising from another partner’s wrongdoing. The misbehaving partner is personally liable for his or her misconduct.
LLPs use pass-through taxation.
LIMITED LIABILITY COMPANY (LLC)
A limited liability company requires a filing with the state, and is subject to the state franchise tax. LLCs are flexible, and allow the owners, or members, to figure out their own ownership and management structure.
The owners of the LLC have limited liability. LLCs have pass-through taxation, unless they elect to be taxed as a C-corporation.
Forming a C-corporation requires filing with the state, and C-corporations are subject to the franchise tax. The requirements for a C-corporation include recordkeeping, annual meetings, no commingling of personal and corporate assets, and adequate capitalization.
The shareholders and managers of a C-corporation have limited liability for the corporation’s debts. But a court may “pierce the corporate veil” and hold the managers or shareholders personally liable if they have not observed the formalities of the corporate structure. This may include commingling corporate and personal assets, fraud, or when limited liability would be unjust to a creditor. Corporations may issue stock.
C-corporations have double taxation. This means that they are first taxed on the entity level so that the corporation files its own income tax return, and then the shareholders pay personal income tax on any dividends or distributions they receive. Though this system seems unfavorable, in some situations it may be beneficial.
The shareholders of a corporation may choose to be taxed as an S-corporation. This means the corporation can use pass-through taxation. To qualify, the corporation must be closely held (with a maximum of 100 shareholders), there must be no nonresident taxpayer or corporate shareholders, and other IRS criteria must be met.
If you are considering forming a business entity, an experienced attorney can help you figure out which entity best suits your needs. Please contact us at 408-779-4700 for a free 20 minute consultation with an experienced San Jose business law attorney at the Law Offices of Steven E. Springer, in Morgan Hill, San Jose, or Fremont.