When you start a business, you need to make several important decisions. Chief among them: which legal business structure will help your company thrive and succeed? 

It’s essential to understand the different types of legal business structures and their implications for your venture. Your choice of entity can impact everything from taxes and accounting requirements to liability and visibility as a public entity. Ultimately, the type of structure you choose determines how your company is organized.

There are many factors to consider when choosing the best legal business structure for your start-up. Depending on your personal circumstances, financial resources, and future goals, one type of organization may be more beneficial than another. 

An Overview of California Business Structures

In California, there are multiple different ways to set up your business. The corporate structure that you choose can impact the way that your company is run, how you pay taxes (and how much you pay in taxes) and whether you will be personally responsible for any debts or liabilities that the corporation incurs.

There are four main types of legal structures: sole proprietorship, partnership, corporation, and limited liability company (LLC). There are also subtypes of partnerships and corporations. Below, we briefly explain the various entities and how they operate.

Sole Proprietorship

A sole proprietorship is exactly what it sounds like: an individual doing business. In most cases, you won’t have to file anything to start a sole proprietorship. If you are operating under any name other than your own, you will have to file a fictitious name statement in the county where your principal place of business is located.

While sole proprietorships are incredibly easy to get started – you generally don’t have to do anything at all – there are drawbacks to this business from. In particular, you have no protection from personal liability with a sole proprietorship. There is also no favorable tax treatment for sole proprietors; you simply pay taxes on any profits as your personal income.

The biggest benefit of forming a sole proprietorship is that it is simple and easy to do. You generally don’t have to file any paperwork or pay any fees to have a sole proprietorship, and your taxes will be relatively straightforward.

However, sole proprietorships provide absolutely no protection for owners. If your business does something wrong or incurs a debt, you will be 100% on the hook for it. If you are engaged in a risky line of work, then you should not use this type of business entity. 

Partnership

Daryl-Reese-Law-Partnerships

A partnership involves two or more people coming together to run a business. There are three types of partnerships: general partnerships, limited partnerships, and limited liability partnerships (LLPs). 

As with sole proprietorships, each partner in any kind of partnership pays taxes on any income or profits realized. Losses can be deducted from taxable income.

General Partnership

In a general partnership, each owner of the business has full control over the day-to-day operations of the company. They are also jointly and severally liable for any debts or obligations of the partnership. If you choose to do so, you can file a Statement of Partnership Authority with the Secretary of State (SoS). However, this is not required for general partnerships.

The main advantage of a General Partnership is that it is easy to form and there are no formalities necessary in order to create one. It is a very flexible way of doing business and can be formed easily by simply agreeing to be business partners. A General Partnership is also relatively inexpensive to form. 

The main disadvantage of a General Partnership is that it has no formal structure, which can cause confusion over who owns what, who’s responsible for what, and how profits will be distributed among partners. Without a clear partnership agreement that spells out individual roles and responsibilities, this can create problems. 

In a general partnership, the partners are responsible for all financial obligations incurred by the business. This can lead to increased risk for the partnership, as there is no guarantee that any one partner will have sufficient financial resources to cover all expenses.

General partnerships do not provide any legal protection against lawsuits or other legal claims that may arise from the operation of the business. For example, if a customer sues your business for damages after getting injured on your property, you could be personally liable for those damages if you are a general partner in the company.

Limited Partnership

A limited partnership (LP) is a partnership with at least one general partner and one or more limited partners. A limited partner is someone who invests in the partnership, but who has limited control over the business’ operations. General partners have no protection from liability, while limited partners are only liable to the extent of their control or participation in the entity. You must register a LP with the California SoS.

The main advantage of a LP is that it offers the flexibility of a partnership with little to no liability for the limited partners. It is relatively easy to form, and does not require the same level of paperwork that a corporation might.

However, LPs come with a distinct disadvantage for general partners. They are fully liable for any debts or liabilities of the business. One strategy to protect the people who might act as general partners is to form an LLC to act in that role, thereby eliminating any personal liability exposure.

Limited Liability Partnership

Finally, LLPs are a specialized type of limited partnership that is exclusively for certain licensed professionals, such as lawyers, accountants, or architects. You must file an Application to Register a Limited Liability Partnership to form a LLP.

Each member of the partnership is a limited partner, and as such, they have limited liability for any obligations that the partnership incurs. However, each member of the LLP has full responsibility for any liabilities that they incur as a result of their own professional activities. For example, a lawyer who commits malpractice will be liable for any judgment that results. For this reason, LLPs are typically required to carry professional liability insurance.

The benefits of a LLP are that each partner’s liability is limited to their own actions and those of a person that they directly supervise. It is also a good structure to incentivize employees, as they may be hired as associates and work their way up to becoming full partners. Finally, LLPs require less paperwork than LLCs and corporations.

The main drawback of LLPs is that they are limited to certain professionals. In addition, each partner must carry liability insurance – which can be pricey.

Corporation

A corporation is a separate legal entity. Owners of a corporation hold shares of stock to represent their ownership, and may have voting rights so that they have a say in how the company is run. Corporations have shareholders, directors, and officers. Shareholders elect the board of directors, which then oversees and directs corporate affairs and decision-making. The day-to-day operations of the corporation are run by the officers or executives hired by the board.

Because a corporation is a separate legal entity, owners have the highest level of protection from personal liability. Shareholders are the owners of the corporation, but the corporation itself owns the business. Corporations exist indefinitely until they are dissolved. 

There are several types of corporations but the most common is a General Stock  corporation. On a tax level, a corporation can elect how it will be treated by the IRS for tax purposes. A C corporation is a corporation that is taxed on its profits, while individual shareholders/owners are only taxed on any income or dividends that they receive. A Subchapter S corp is a pass-through entity, where any profits and losses are passed through to the individual owners and taxes are paid on an individual level.

To form a corporation, you will need to file Articles of Incorporation with the Secretary of State, adopt bylaws, and hold directors and shareholder meetings as required by law. You will also be responsible for franchise taxes and routine filings.

Corporations have many benefits that make them a favorite among businesses. For instance, they are protected from personal liability, which means the owners cannot be held personally liable for the corporation’s actions. Corporations also continue to exist as long as they are active. A corporation will not die simply because its leader dies or retires. Corporations can issue stock and are owned by shareholders.

Despite the benefits of corporations, they also come with disadvantages. For example, corporations are required to hold annual meetings and approve minutes detailing the proceedings of the shareholders and directors. Corporations are also required to file an annual report with the secretary of state. 

Limited Liability Company

A limited liability company (LLC) is an entity that combines features from both corporations and partnerships. It provides the flexibility and ease of a partnership with the liability protection of a corporation. A LLC may be taxed in different ways, depending on how it is formed and the number of members.

To form a LLC, you will need to file Articles of Organization with the state. In addition, a LLC should have an operating agreement that spells out how it will be run. This document does not need to be filed with the state. 

Many people prefer using a LLC to form a business because of the many benefits that it offers. For example, under a LLC, the owners of a business can shield their personal assets from being seized by creditors in the event that the company fails and goes bankrupt. In this type of situation, only the assets owned by the business would be subject to being seized by creditors.

There are certain disadvantages when using a LLC instead of other business forms. For example, LLCs are only recognized in a few states. Also, a LLC can be more complicated and expensive to create than a sole proprietorship. You may need a lawyer to form a LLC, and it may cost more than starting a sole proprietorship. Additionally, LLCs have some organizational requirements that must be met in order for the LLC to stay in compliance with state laws.

How Do I Select the Best Legal Structure for My Start-Up?

Your business’s legal structure plays a major role in the ultimate success of your company. Depending on what form you choose, it will affect everything from your ability to raise money to how much you pay in taxes, and how your company is managed. Perhaps most importantly, the type of entity you choose will have a major impact on your personal liability for any lawsuits against the company or debts.

Many businesses could be formed using two or more of the forms listed above, which can make it harder to choose. There are a number of things to consider when choosing an entity type, including:

 

    • Flexibility: when you start a business, you probably are hoping that it will expand and grow over time. Take a look at your business plan to see what the ultimate goal of your company is. You should pick a structure that best aligns with these objectives.
    • Liability: we live in a litigious society. With this in mind, think about the level of risk you are willing to undertake with your business. If someone sues you for a personal injury caused by your business’ operations, are you willing to put your personal assets on the line? A corporation gives you the highest level of protection from liability, followed by a LLC. If you aren’t concerned with liability, you may want to form a sole proprietorship or a partnership.
    • Investment: if you need funding from a bank, investor, or venture capitalist for your start-up, you will almost certainly need to form a corporation or LLC. 
    • Control: when you have a great idea, you might want to maintain some level of control over how it is monetized. When you bring in other people, it can reduce the amount of control that you have over the business. Sole proprietorships and single member LLCs give you the highest degree of control over your company. You may also be able to negotiate a greater amount of control in a partnership agreement. In some cases, you must give up some control to form a corporation.
    • Complexity: there is a certain amount of paperwork and bureaucracy involved in any business. The corporate form that you choose can add to these burdens with reporting requirements and additional tax returns to complete. Corporations and LLCs typically have the highest level of reporting and government oversight, while sole proprietorships and partnerships have little to no reporting requirements. All entity types other than sole proprietorships and single member LLCs will also typically require some type of operating agreement or other formal paperwork that sets out the rights and responsibilities of each owner.
    • Taxes: nobody wants to pay more taxes than they have to, which is why it is important to choose a business form carefully. With a corporation, you be paying business taxes as well as personal income taxes. Many other business structures allow you to disregard the entity and only pay taxes on your own income or profits. A tax professional can help you determine which form is right for you.
  • Owner Compensation: in many business forms, owners can pay themselves with considerable flexibility. In a corporation, the IRS requires that a business owner working in the company must pay themselves a reasonable salary as an employee in addition to any compensation they may receive as a shareholder. 

 

Every legal business structure has its own advantages, disadvantages, and risks. It’s important to choose the one that is best suited for your business based on your specific needs and goals. Choosing the most appropriate legal structure is a crucial step in starting any new business. It can be difficult to change business forms at a later date.

The best way to make the right decision for your company is by consulting with an experienced California business formation attorney. They will listen to your story, and help you choose a business structure based on your priorities and unique needs.

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Entrepreneurs are risk-takers by nature. That doesn’t mean that they should gamble with the fundamentals, however. Before you bring your great idea to life, you must choose a business structure that will allow your company to thrive.

Daryl Reese Law PC advises companies of all sizes in all aspects of business law. Our goal is to work collaboratively with our clients to come up with innovative solutions that help them achieve their goals. To learn more or to schedule a consultation with a California business attorney, give our law office a call at (707) 858-5000 or fill out our online contact form.

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