Business Entity Decision Guide 101 (California)

What Type of Business Entity Should I form in California?

Business Entity Choice

The first question I receive from anyone looking to start a business is usually What type of business entity should I form?

The answer (to no one’s surprise) is “it depends.” The reason this very stereotypical lawyer answer is given is there are pros and cons to all business entities. Each business owner has a unique plan for their business.

Each business owner has their own pain points (fee sensitive, lack of desire to follow corporate formalities, etc.) and thus each type of business entity provides its own advantages and disadvantages.

When deciding on what type of business entity to choose, business owners should weigh the following five factors:

Five Key Factors to Consider When Choosing a Business Entity:

  1. Legal Liability
  2. Tax Consequences
  3. Governing Law of State of Formation
  4. Industry Requirements
  5. Exit Strategy

With the following breakdown of business entities, you should have a better idea of which entity best suits your needs. With that said, consult with a business attorney prior to forming a business. This will ensure that your needs are met.

Business Entity Types

Sole Proprietorships

A sole proprietorship does not carry any legal distinction between the business and the owner of the business. There is no documentation that is required to be filed with the Secretary of State or other governmental entities. This is an attractive feature for many who are concerned with the cost of starting a business. Sole Proprietorships also do not have follow corporate formalities. This, however, does not come without drawbacks.

There is unlimited personal liability for the owner of the business who operates as a Sole Proprietor. If the business incurs any sort of debts, financial obligations, or liability,  the owner of the business will be personally responsible for those obligations. One other drawback is that banks and investors may be hesitant to lend money or to a sole proprietorship. Thus, growth of the business may be delayed.

Types of Businesses that may consider operating as a Sole Proprietorship: Small home-based businesses just starting out without much capital,

General Partnerships

A General Partnership is an association of two or more individuals or entities conducting a business together. General partners share in the profits and losses of the enterprise. Similar to a Sole Proprietorship, in a General Partnership, there are no corporate formalities. While a General Partnership may be formed without a partnership agreement, that is generally ill-advised. Easy and cost efficient to form, this is an appealing entity for individuals who are cost sensitive and do not want to follow a corporate structure.

One glaring drawback to this type of entity is that each partner in the General Partnership assumes unlimited liability for all the liabilities, debts, and even torts committed by any partner in the ordinary course of business. In addition, each partner holds a high fiduciary obligation to every other partner in the General Partnership. The standard for such is a duty of loyalty, good faith, and fair dealing. Much like a Sole Proprietorship, this is generally not the best route unless costs and structure are critical issues.

Types of Businesses that may consider operating as a General Partnership: Dental and Medical Practices, Law Practices,

Limited Partnerships

A limited partnership is similar to a General Partnership in that it is also an association of two or more parties. The significant difference is that in a Limited Partnership, general partners and limited partners exist. A limited partner’s liability is reserved to the amount invested in the Limited Partnership and the limited partner does not manage the business. The general partner in a Limited Partnership has unlimited liability and management duties.

A benefit of having a limited partnership is that it allows outside investors to supply capital to the business while maintaining limited liability. As mentioned earlier, a limited partner’s liability extends only to that of the investment in the partnership. Another advantage of this entity is that all of the partnerships profits and losses flow directly through the individual limited partners (if corporate formalities are followed) and the Limited Partnership itself is not taxed.

Unlike a General Partnership, a Limited Partnership requires a certificate of limited partnership to be filed with Secretary of State. (Form LP-1) In California, and other states, a limited partnership agreement must be executed by all parties involved.

Types of Businesses that may consider operating as a Limited Partnership: Law Firms, Accounting Firms, Investment Firms.

Corporations

C Corporation

A C corporation is traditionally the most common type of corporation used. This, however, is rapidly changed because C-Corporations face double taxation.  The corporation is first taxed for the profits it generates and then the shareholders are individually taxed for their dividends received from the corporation.

This is highly desirable for those seeking protection against personal liability for the debts and liabilities of an entity. Shareholders can, however, be held personally liable if corporate formalities are not met (i.e. piercing the corporate veil) . Additionally, venture capitalists typically prefer to invest in these types of corporations. A C-Corp is able to issue different classes of stock to outside investors and employees of the corporation. Generally speaking, a C-Corp is one of the more expensive entities to form an maintain.

Types of Businesses that may consider operating as a C-Corp: Technology Businesses, Bio Tech Companies, Companies looking to go public, Companies with over 100 shareholders.

S Corporation

An S corporation, much like a C corporation, is a type of corporation that allows its owners protections from personal liability. After filing as a corporation, the corporation may elect to be treated as an S-Corp by the IRS by filing IRS form 2553.  If this election is not made, by default the corporation will be treated as a C-Corp. S-Corp’s  are not taxed at the corporate level and all profits and losses to flow through the shareholders, thus avoiding double taxation.

S corporations provide protection to shareholders from being personally liable for the entity’s debts and/or liabilities. Much like the C corporation, S corporations require strict corporate formalities. Some of these include, but not limited to: director and shareholder meetings, up-to-date by-laws, and records maintenance. S-Corps require that all shareholders be individuals (no entities) and US Citizens or residents.

Types of Businesses that may consider operating as a S-Corp: Construction Companies, Dental Practices, Medical Practices,

Limited Liability Company’s (LLC)

An LLC is a type of business entity that’s a hybrid between a corporation and a partnership. LLC’s provide protection from personal liability while affording flexibility in splitting the profits and losses. By default a California LLC is governed by state law however you owners can change the default rules through a well-drafted operating agreement.   Corporate structure and formalities are not necessary, yet outside investors can still invest in an LLC. Another significant benefit is that the profits and losses flow through members. LLC’s. Further, to someone who is inclined to keep filing fees and costs down, this may be the most attractive option. While investors can invest in LLC’s, they may be hesitant to do such. Since corporate formalities and structure are not required, and meeting minutes are not mandatory to be kept, there is potential for little transparency into the company.

Types of Businesses that may consider operating as an LLC: Real Estate Holding Companies,

As mentioned earlier, it is highly advised to consult with an experienced business attorney prior to establishing an entity to ensure that your business is set up to provide the most benefit to you. If you have any questions, please feel free to reach out to one of our experienced business entity attorneys.

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