There comes a time in the life cycle of your business when you need to consider the type of entity you want it to be.
If you’re a reader of this blog, then you’re already focused on business strategy, and legal planning should be a part of your arsenal. As an attorney that primarily works with entrepreneurs in southern California, a frequent question I’m asked is how to formalize a business and what the best entity route to take is. There is a virtual alphabet soup of options out there, and the IRS self-help info available is not what I’d call an enjoyable read. Here is a handy “cheat sheet” to introduce your entity choices and important considerations, to help you maximize your time with your tax professional, business consultant, and lawyer. This should not be the substitute for legal advice, but a way to help you start the conversation and organize the research material you gather.
Why does choice of entity matter?
Your business is unique, and your entity should be, too. What’s right for your artisan jam business may not be right for a tech startup. It affects how much you’ll pay in taxes, what happens when one of your vendors or customers sues you, how you grow your business in terms of raising money, bringing in partners and employees, and how much paperwork you’ll have to do.
Sole Proprietorship is a common form for small businesses that do not have a lot of startup capital. The setup paperwork and licensing involved is primarily at the city or county level. You are taxed as an individual, and all debts, profits and liabilities are yours personally. This is a popular choice in California to avoid paying the corporate tax. However, it leaves you unprotected in case of a lawsuit, and makes it difficult to raise money as you grow.
“C Corp” is shorthand you may have heard for a “C Corporation.” Incorporating your business will create a separate entity. It is taxed and treated separately, and there are stringent filing requirements with the secretary of state. You’ll have to register for a tax ID with the IRS and state in order to pay yourself. You’ll have to maintain corporate paperwork, file updated statements and pay fees regularly. The benefits are limiting your liability in case of a lawsuit, you can issue stock or offer stock options to employees, and you’ll appear more attractive to investors and talent.
Variations on the theme: S Corp
You may have heard about the “S Corp.” S Corporation is not a separate entity, it is an election you can make with the IRS to have your corporation taxed differently. You enjoy the legal protection benefits, but your profits and losses “flow through” to your personal return. There are restrictions on who may own a majority share in an S corporation, such as U.S. residency. S Corps are still subject to the yearly franchise tax in California as well.
A Limited Liability Company is a hybrid between a corporation and a partnership, and is very customizable. It allows members to have the limited liability of a corporation without the paperwork compliance load, and the tax benefits and hands-on management control of partnership. Generally it requires more than one member.
If you want to run your business with one or more people (or companies), a general partnership is another option. California requires filing with the secretary of state, and apportionment of taxes amongst partners. All partners can be directly involved in managing business affairs, but also can be held personally liable.
A Limited Partnership is a variation on the partnership structure to allow partners to enjoy tax benefits and limited liability. The catch is, only one General Partner is permitted to manage the day to day affairs of the business, and does not have limited liability. The Limited Partners only maintain a passive investment role. This may be more appropriate if you are seeking to partner with other corporations.
But wait! There’s more!
As you can see, there are many choices too complex to fully analyze in one post. I haven’t even dipped a toe into the fascinating waters of professional entities, and business entities you can form in other states. Hopefully this will give you some food for thought and discussion topics with your business advisors. —Nicholle Mineiro, http://lawbydesign.wordpress.com