One of the first big decisions business owners make when starting their companies is to determine which type of business structure they will use to legally start their business. The choice of entity plays a significant role in the life of a company, from exposure to liability to federal and state tax obligations. For this reason, it is important to consult with an attorney prior to starting the process.

In California, there are six basic types of business entities: corporation, limited liability company, limited partnership, general partnership, limited liability partnership, and sole proprietorship. Each of these structures comes with unique advantages and disadvantages. With the exception of a sole proprietorship, you will be required to file formation documents with the California Secretary of State (SoS) in order to launch your company.

At Daryl Reese Law PC, we assist clients with all aspects of business law, from initial formation to drafting and reviewing contracts to litigation and compliance issues to winding up and dissolution. Below, we have put together a guide to help you understand the basics of corporate formation in California. If you have additional questions, reach out to our law firm to schedule a consultation with a member of our legal team.

An Overview of California Business Structures

Entrepreneurs in California have multiple options when it comes to the form that their business will take. Because there are both legal and tax ramifications for each choice, you should always talk to an attorney and tax professional before making a final decision. A lawyer can also help to ensure that your paperwork is completed and filed properly and that you understand the hierarchy of governing authorities to properly govern your business.

There are six basic types of business structures in California: corporation, limited liability company, limited partnership, general partnership, limited liability partnership, and sole proprietorship. The best choice for your business depends on a number of factors, including:

  • Your planned ownership and management structure;
  • Your income tax situation;
  • Your potential exposure to liability as a business owner;
  • Your investment and financing needs; and
  • The expense and time involved in forming the entity.

Understanding the difference between each type of business structure can help you make a more informed decision about which option is right for your company.

Corporations

A corporation is a legal entity that is separate from its owners. The corporation itself is owned by shareholders. This type of business entity provides a high degree of protection for the owners, as any debts or liabilities incurred are generally the responsibility of the corporation itself – not its individual owners.

Because a corporation is a distinct entity, it is taxed as such. In addition, any owners and/or shareholders will be taxed on income received or profits gained through the operation of the business. 

There are different types of corporations, with the most common being a general stock corporation. For tax purposes, a corporation can choose how its profits and losses will be treated by the IRS. A C corporation is treated as a separate entity for taxation, which means that the corporation itself is taxed on its profits. Shareholders/owners of a C corp are only taxed on income or dividends that they receive. By contrast, a S corporation is considered a “pass-through” entity, so that any profits and losses are paid by the individual owners or shareholders.

To form a domestic (California-based) corporation, you will need to file Articles of Incorporation with the SoS. Once the SoS approves the articles, then the corporation will begin to exist. The corporation will continue its existence until the owners dissolve the corporation. There is a slightly different process for registering a foreign corporation in California, which involves applying to the SoS for recognition as a foreign corporation.

Every corporation that is incorporated, registered and/or doing business in California must pay an annual franchise tax even if  they did not conduct any business in the state during the tax year. There are also certain filings and fees that must be paid to keep your corporation active. 

Limited Liability Companies

A limited liability company – commonly referred to as a LLC – provides the same legal protections as a corporation for its owners, who are referred to as members. It allows individuals to run a business or to hold assets. Like corporations, a LLC is a separate legal entity that shields its members from personal liability, with some exceptions.

LLCs may be formed and managed by one or more members. Depending on its structure, a LLC may be disregarded entirely for tax purposes, taxed as a partnership, or taxed as a corporation. 

To form a LLC, you will need to file Articles of Organization with the SoS. In addition, the LLC should have an operating agreement that outlines how the business will be run. This operating agreement is not filed with the state.

Limited Partnerships

A partnership involves two or more people who run a business together as co-owners. A limited partnership is a specific type of partnership. In a limited partnership, there is at least one general partner and one or more limited partners. The limited partners have a minimal amount of control over the operations of the business, if any, while the general partner is responsible for the day-to-day management of the business. 

For this reason, limited partners are only responsible for the debts and liabilities of the corporation up to the extent of their control or investment. By contrast, general partners are personally liable for the partnership’s debts and obligations.

In any partnership, the business itself is not taxed. Instead, each partner is responsible for paying taxes on their income and share of profits and losses. This can be advantageous in certain situations, but may make for more complex individual tax returns.

To form a limited partnership, you must file a Certificate of Limited Partnership with the SoS. You can also register an out-of-state (foreign) limited partnership with the state.

General Partnerships

A general partnership is another type of partnership where all business owners are jointly and severally liable for any debts or liabilities that the business incurs. Each general partner has the ability to make binding decisions for the entity and to control and operate the business. As with limited partnerships, general partners are individually responsible for paying taxes on any income that they receive through the partnership.

Registering a general partnership with the state is optional. If you choose to do so, you will need to file a Statement of Partnership Authority with the SoS.

Limited Liability Partnerships

Limited liability partnerships (commonly referred to as LLPs) are a type of partnership that can only be formed by professionals in certain industries. Specifically, partners who are engaged in the practice of accounting, law, architecture, engineering, or land surveying can form an LLP. In addition, a business that provides services or facilities to a California or foreign LLP can also form a LLP.

To register a LLP in California, partners must file an Application to Register a Limited Liability Partnership with the California SoS. LLPs are also typically required to maintain a certain level of insurance in accordance with state law. The LLP itself must pay the annual $800 franchise tax fee, but taxes on income of the partnership are paid by individual partners.

Sole Proprietorships

A sole proprietorship is a business structure that an individual can use to own and operate a business. The sole proprietor has complete control over the operation of the company. At the same time, a sole proprietor is personally liable for any debts and liabilities of the business.

A sole proprietorship is the simplest form of business. It is sometimes referred to as a single-owner entity. Independent contractors that run their own business without registering with the Secretary of State operate as sole proprietors. It is the most common type of business in the U.S. According to the Tax Foundation, 73.1% of businesses in the United States are sole proprietorships.

Any taxes on the income of a sole proprietorship are paid by the owner of the company. There is no requirement to file any documents with the state to start a sole proprietorship. However, if you plan to use a name other than your own for the business, then you must file a Fictitious Business Name Statement in the county where your principal place of business is located. Unlike other types of business structures, a sole proprietorship automatically ceases to exist upon the owner’s death.

What Business Structure Is Best for My Company?

When it comes to choosing an entity type, there is no one-size-fits-all solution for companies. The best business structure will be based on your specific needs, risk tolerance, and other factors.

First, you must evaluate the number of owners that your business will have, and how involved they will be in the management of the company. If you will be the sole owner, then you can operate as a sole proprietorship, a single-member LLC, or even a corporation. With two or more owners, you can form a partnership, a LLC, or a corporation. When there are many owners of a company, a LLC or a corporation are typically the best bet.

Second, you will need to consider how the entity will be taxed. Sole proprietorships, partnerships and LLCs are generally “pass-through” entities, which mean that the business owners pay taxes based on their share of their profits, rather than the company itself. By contrast, owners of corporations do not report their share of corporate profits on their personal tax returns. Instead, they only pay taxes on the income, bonuses, and dividends that they actually receive. Generally, paying taxes as a corporation is more complicated – but may lead to a lower overall tax bill based on the favorable treatment of corporations under the tax code.

Third, it is important to evaluate your potential liability before deciding on a corporate form. If your company is engaging in business that comes with more risks then you will want to choose a structure that shields you from personal liability. Without this type of protection, an aggrieved customer or other claimant could go after your personal assets. Corporations and LLCs provide the highest level of personal liability protection for business owners.

Fourth, consider your investment and financing needs. If you need a bank loan or investors, then you will almost certainly need to form a LLC or a corporation. If you don’t need financing, then a partnership or sole proprietorship may be a good option for you.

Fifth, think about whether your proposed business structure requires paperwork and fees. Sole proprietorships and general partnerships are typically easier to set up, and often do not require filing any documents with the state or paying any fees. By contrast, corporations, LLCs, LLPs and limited partnerships must file formation documents with the state and pay a fee. While the amount of paperwork and fees involved shouldn’t be the primary factor in which business entity you choose, it may be a deciding factor after you have weighed other considerations.

Choosing the right type of entity for your business can be difficult, but it is important to understand what your options are before you decide which one is best for your needs. Each type of business structure comes with its own set of responsibilities and rules that you must follow in order to operate within the law. The advice of a trusted attorney can be helpful when deciding which type of business structure to choose for your company.

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How Our Law Firm Can Help

Deciding to start your own business can be both exciting and overwhelming. There are a lot of decisions that must be made before you can really get to work – starting with choosing how you will do business. By choosing the right business entity type for your company, you can take advantage of its benefits and be prepared for any future issues as a result of running your small business or large corporation.

 

Daryl Reese Law PC provides legal representation and counsel to businesses of all sizes throughout California. We’ll work with you to choose a corporate structure that fits your needs as a business owner, and guide you throughout the process. To learn more or to schedule a consultation with a California business formation lawyer, give us a call at (707) 858-5000 or fill out our online contact form

 

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