Proprietorship, Partnership, Limited Liability Company (LLC), or Corporation?
Which business entity form is right for me and what is an S-Corp. anyway?
One of the first questions that an entrepreneur must face when forming a startup business is what type of business entity to form, if any. The main reason anybody forms a fictitious business entity is for personal liability protection. By forming an LLC or a corporation, a business owner can protect their personal assets, i.e., their home, car, savings accounts and other personal assets from the businesses liabilities. If the business is ever sued, then the business owner’s personal assets are shielded from liability and cannot be touched (assuming the corporation was properly formed and maintained, and all of the corporate formalities were followed). There are many other considerations to consider when forming a fictitious entity and you really should consult with a lawyer and a tax professional before making any decisions. This blog post will discuss each of the common types of fictitious business entities and the pros and cons of each. After reading this blog post, you should have a pretty good idea of which type of fictitious business entity you should form for your entrepreneurial endeavor. At the bottom of this blog post is a summary table of all of this information for your convenience and ease of reference.
Sole Proprietorship
A sole proprietorship is exactly that; a business that is owned and operated solely by one person for profit. The sole proprietorship is attractive because of the simplicity. If you started doing business without filing for a LLC or corporation, then you are a sole proprietor. To form a sole proprietorship, you don’t have to file anything with the state to form a fictitious entity because you don’t have a fictitious entity. However if the sole proprietor is operating under a fictitious business name (i.e., a “doing business as” (DBA) name), the business must file a fictitious business name filing with the California Secretary of State (SOS). The sole proprietorship has other perks such as, you are only taxed once because there is no corporate tax, since there is no fictitious entity so, the owner will report the profits and losses on their individual tax returns; also the sole proprietorship is still considered a business for all intent and purpose and thus may apply for business loans, and set up IRA’s or self-employed retirement plans and may deduct at least a portion of medical insurance premiums. Further, this is the easiest form of business to dissolve; the sole proprietor owner can terminate the business at anytime or the business will terminate at the death of the owner. The single largest downside for a sole proprietor is that there is no corporate shield and so the owner’s personal assets are always at risk and the owner is liable personally for all of the debts of the business. Another downside to the sole proprietorship is that it cannot take advantage of tax savings options such as self-employment tax savings. All the income flows to the owner of a sole proprietorship automatically and thus all income is subject to self-employment taxes. The sole proprietorship also does not provide the privacy that forming a fictitious entity allows. If you want to open a business without your involvement being public, then the sole proprietorship is not for you. Also, if you plan on raising money for your business, you may want to consider a Corporation or LLC. Selling ownership interests in a sole proprietorship can be difficult. Last, forming a sole proprietorship does not allow the use of the “LLC” or “INC” designation at the end of the business name, which are the most permanent forms of business structure, and using these designations conveys trustworthiness and dependability in any person or entity that you do business with such as your customers, vendors, and clients.
General Partnership
A general partnership is very similar to a sole proprietorship but instead of only one owner, a general partnership has more than one person that starts the business together for profit. This type of business entity also does not require any formal filings to form, however the partnership must acquire a taxpayer identification number and if operating under a fictitious business name (i.e., a “doing business as” (DBA) name), the business must file a fictitious business name filing with the California SOS. Similar to the sole proprietorship, this entity is fairly easy to dissolve, however the partners must either be in agreement, or the partnership dissolves if one partner dies or withdrawals from the partnership. The partners should have a partnership agreement that deals with such situations. The partners all have equal management rights; the details of these rights can be addressed in the partnership agreement with specificity. With a general partnership there is no double taxation so the profits of a general partnership are taxed only once and each partner reports his share of profits and losses on his individual tax returns. The partnership does have to file a tax return, but it’s an information return only. The general partnership is a business for all intent and purposes so it may utilize resources such as business loans and may form IRA’s or self-employed retirement plans for the partners, and medical insurance premiums are at least partially deductible. The general partnership does not provide limited liability protection so there is no corporate shield and the owner’s personal assets are always at risk. The owner is liable personally for all of the debts of the business. Another downside to the general partnership is that it cannot take advantage of tax savings options such as self-employment tax savings. All the income flows to the partners of the general partnership automatically and thus all income is subject to self-employment taxes. The general partnership also does not provide the privacy that forming a fictitious entity allows. If you want to open a business without your involvement being public, then the general partnership is not for you. Similar to the sole proprietorship, if you plan on raising money for your business, you may want to consider a Corporation or LLC because selling ownership interests in a general partnership can be difficult. Last, forming a general partnership does not allow the use of the “LLC” or “INC” designation at the end of the business name, which are the most permanent forms of business structure, and using these designations conveys trustworthiness and dependability in any person or entity that you do business with, such as your customers, vendors, and clients.
Limited Partnership
A limited partnership is very similar to a general partnership except at least one of the general partners is strictly a passive investor that has no management rights. Only that passive investor partner is granted limited liability protection. It is imperative that the passive investor partner, i.e., the limited partner, has absolutely no management rights in order to maintain their limited liability protection. The limited partners exposure is simply the amount of money that they invested. The other partners manage the partnership and are subject to the unlimited personal liability for the debts of the partnership. Also dissimilar to the general partnership, the limited partnership must be formed with a written agreement amongst the partners and they must file a certificate of limited partnership with the California SOS.
C-Corporation
A C-corporation is a fictitious business entity that creates a completely separate “person” from its owners, which are called shareholders. The shareholders enjoy limited liability protection and will not be held personally liable for the corporation’s debts as long as the corporation was formed and maintained properly and all corporate formalities were followed such as maintaining annual corporate minutes. A “C” corporation is the basic corporation and all corporations will be “C” corporations unless the owners make an election with the Internal Revenue Service (IRS) to be an “S” corporation (discussed in more detail below). To form a C-corporation you must file articles of incorporation with the California SOS, which identifies the corporate name, the purpose of the corporation, the name and address for the agent for service of process and the number of shares of stock authorized. Within ninety days of forming the corporation the owners must also file their first annual statement of information at the California SOS, which identifies the address of the principal location of the business, the directors and officers, the agent for service of process, and again, the type of business. The shareholders elect the directors of the corporation, and the directors appoint the officers to run the business. Typically in small startup businesses, the shareholders are the ones forming the corporation, and they also are the directors and the shareholders. It is not uncommon for one person to be all three officers, the only director, and the sole shareholder. The owners will also need to adopt bylaws, and issue stock to the shareholders. The fictitious entity must also obtain a taxpayer identification number from the IRS and the California Franchise Tax Board (FTB). A corporation can endure forever until it is formally dissolved at the SOS. A corporation is considered the most stable fictitious business entity and is not affected by the death or withdrawal of a shareholder. A shareholder may sell shares of stock and/or the corporation may sell shares of stock from its treasury to raise capital, of course subject to state and federal securities laws. If substantial capital infusion is needed, the corporation may go public and sell shares on an exchange in the open market. Obviously the corporation can utilize resources like business loans, and may offer its’ shareholders and employees full tax-deductible fringe benefits such as retirement plans, medical insurance, and medical expense reimbursement. The main concern with a corporation is that it is subject to double taxation because the income is taxed once at the corporate level, and then again at the individual shareholder level. This concern can be alleviated with an “S” election with the IRS (discussed in more detail below). Dissolution of a corporation requires filing a statement of intent to dissolve with the SOS, and at least 50% of the shareholders vote. The corporation also provides for privacy if you want to partake in a business without your involvement being public because shareholders are not disclosed on any public forms. So, as long as you are not an officer, director, agent for service, or incorporator, your personal name will not appear in public view.
S-Corporation
An S-corporation is basically the same as a C-corporation but it has made an “S” election with the IRS. This allows it to be taxed like a pass-through entity and avoid double taxation. The profits are taxed once because each shareholder reports her share of profit and loss on her individual income tax returns and all profits and losses automatically flow to the shareholders at the end of each year. The S-corporation is limited to only 75 shareholders and any employee shareholder owning 2% or more of the outstanding, issued stock are restricted from the fringe benefits. The corporation does not pay taxes, however is subject to a minimum fee each year; in California that fee is $800.
Limited Liability Company (LLC)
A limited liability company (LLC) is similar to a corporation with an “S” election with the IRS in many ways. It is considered an unincorporated business entity and the owners enjoy the limited liability protections, and pass-through income (i.e., no double taxation). Each owner, called a member, reports her share of profits and losses on her individual income tax returns. The LLC may elect to be taxed like a C-corporation if the members prefer. To form this type of fictitious business entity the owners must file articles of organization with the California SOS identifying the LLC’s name, the business address, the agent for service of process, how the LLC will be managed, what the purpose of the LLC is, and who the members of the LLC are. The members of the LLC are the owners of the LLC, similar to the shareholders of the corporation. Within 90 days of filing the articles of organization for the LLC at the SOS, the member must adopt an operating agreement and file it with the SOS, must obtain a tax identification number with the IRS and FTB, and must file their first annual statement of information with the SOS identifying the LLC name, the business address, the managers and/or members, the agent for service of process, the type of business the LLC is conducting, and the CEO if one is elected or appointed. The LLC is a business entity for all intent and purposes and may tap into resources for business loans and tax-deductible fringe benefits are available similar to a corporation. Dissolution of the LLC can occur by filing articles of dissolution with the SOS after all the debts of the business are addressed. Although the LLC does not have shares, it is common for the operating agreement to create “units” which have a similar effect as shares of a corporation.
Conclusion
There are many considerations when deciding what type of business entity to form for your startup. The information provided above is a lot of the main considerations, but each person’s individual circumstances make the inquiry very personalized. You should consult with an attorney and a tax professional before making any decisions in this regard. Contact your full service business and legal affairs department at A.E.I. Law for all of your entrepreneurial needs.
