Here’s an outline of the different ways you can organize your business. Since I cannot give you legal advice as to which of these is best, I hope that review of this information will assist my clients in deciding the best path forward. This is not legal advice, just general information.
Sole Proprietorship
A sole proprietorship is the most basic form of business organization. It is consists of an individual doing business in their own name, or under a fictitious name. For example, Joe Smith might own a shoe repair shop which he calls Joe’s Shoes. The only government filing necessary for this is a fictitious name statement that has to be filed with the County Clerk, and then published in the local newspaper.
Sole proprietorships report their income on Schedule C of an individual’s tax return. The individual needs to ask the IRS for an employer ID number, which will apply to not only that sole proprietorship, but any other one operated by the taxpayer during the rest of his or her life. Although a sole proprietorship is a simple way to do business, it does not insulate the individual from personal liability from the business. Therefore, most small business people do business in other forms.
General Partnership
The general partnership is basically a sole proprietorship times two. For example, Abraham Lincoln entered into a general partnership with a man named William Berry to operate a general store. In California, a general partnership can be established even if there is no formal written agreement; it can be proved by the conduct of the parties. In a general partnership, both partners are 100% liable for all the debts and obligations of the business, even if the liability was contracted by the other partner without their knowledge. This can lead to unforeseen problems, and as a result, very few people do business as general partnerships anymore.
Limited Partnership
Limited partnerships are now used mostly for real estate projects or hedge funds. A limited partnership is operated by a general partner, who is personally responsible for liabilities of the partnership. In order to mitigate this, usually the general partner is a corporation. Limited partnerships are what is known as “disregarded entities.” That means that the limited partnership itself does not pay any federal taxes. It prepares an information return and then gives a report to each partner as to its percentage share of the income items and deductions of the partnership. This reporting is done on a Schedule K-1. Limited partners have no say in the day-to-day management of the business. Limited partnerships are complicated and as a result, as stated above, they usually only used for real estate or hedge funds. One of the problems with limited partnerships is that historically, they were limited and as to the number of shareholders they could have. Having more than 100 shareholders would result in the IRS classifying the partnership as a corporation, defeating the ability of the limited partners to take advantage of depreciation and other deductions resulting from the partnership’s investment in real estate. The limited partnership has almost entirely been superseded by the limited liability company, discussed below.
Corporations
A corporate structure completely separates management on the one hand, and shareholders on the other. Day-to-day operations are conducted by officers, such as the president, chief financial officer, vice presidents, etc., while the general policy-making and significant decisions are made by the Board of Directors. The Board of Directors is elected by the shareholders. The shareholders need not be directors or officers. Nearly all large companies in the United States are corporations, and, in particular, the variety of corporation known as a “C Corporation” because the provisions governing them for tax purposes are contained in Subchapter C of the Internal Revenue Code.
A C Corporation is not a disregarded entity. It is taxed separately. Any distribution of income to the shareholders is made via dividend, and shareholders have to pay a tax on the dividend. Although currently that dividend tax rate is generally 15%, it is still double taxation. That is, after the corporation has already paid taxes on the income, that income is taxed for the second time when it’s distributed shareholders. However, for most small and medium-size businesses, this double taxation is not really an issue, because the corporate officers at working day-to-day for the business and are usually its majority shareholders. These corporate officers can merely increase their salaries, resulting in a deduction for the Corporation. Although the IRS theoretically can go to the Corporation say that its offices are receiving salary that is too high, and construe a portion of their inflated salaries, as constructive dividends, it’s pretty rare for the IRS to do this.
There are a large number of tax benefits available to a C Corporation, including enhanced pension capabilities; these would be better explained by a tax lawyer or a tax accountant. But the primary benefit for small and medium-size businesses in using the corporate form is the protection from liability afforded shareholders. Shareholders generally are not liable for the debts of the corporation. There are exceptions to this rule, which are set forth below under Piercing the Corporate Veil.
Shareholder Agreements
One of the characteristics of a corporation is that its shareholders are able to freely transfer their share ownership to other people without the permission of other shareholders. Shareholders can, if they wish, enter into a shareholders agreement restricting this free transferability. Most of these shareholder agreements contain “buy-sell” covenants that allow other shareholders to have the first right to buy out the interest of any shareholder who wants to sell. For example, one of the shareholders might die or get divorced. Especially when the corporation is held by only a few people, the other shareholders might not want to have outsiders become shareholders of the company, and under a properly written shareholders agreement, would have the ability to buy out the estate or the ex-spouse on favorable terms.
Subchapter S corporation
Subchapter S corporations are governed by, as you would guess, Subchapter S of the Internal Revenue Code. Like limited partnerships, and limited liability companies, Corporations are disregarded entities. However, it should be noted that state law, such as the California Corporations Code, has nothing to do with whether a corporation is an S corporation or a C Corporation. That is entirely determined by the election you make when you form the corporation and get an employer ID number. You can always elect S corporation status by filing Form 2553 with the Internal Revenue Service within 2 months and 15 days, however.
An S corporation is limited to 100 shareholders, of which with, with some exceptions, all need to be individuals who were either US citizens or US residents. These exceptions are, other S corporations which are owned by one single US citizen or resident, a living trust, some irrevocable trusts, and single member LLCs.
The taxation of an S Corporation is almost the same as that of an LLC, with some minor differences can that can be important. These are discussed below under S corporation versus LLC.
Close Corporation
A close corporation is a special variety of corporation provided for an California law. Other states have similar provisions. In California, a close corporation is limited to 35 shareholders. The primary benefit of electing to be close corporation is that it eliminates the need for many of the corporate formalities, such as holding an annual meeting. This reduced need for corporate formalities can make it harder for a litigant or creditor to pierce the corporate veil.
Limited Liability Company
A limited liability company, known as an LLC, was first created in Wyoming. An LLC is structured to take advantages of the best features of a corporation and a limited partnership. An LLC can be managed either by members or by managers, who need not be members. An LLC is a disregarded entity. But also provides the same level (and more) of liability protection for its members as does a corporate structure. Instead of articles of incorporation and bylaws, or a partnership agreement, a limited liability company has an operating agreement. This operating agreement is highly customizable, and usually includes provisions restricting the transfer of the membership interest to other persons, including “buy-sell” agreement provisions. Our operating agreement template includes a standard buy-sell provision.
Another benefit of LLCs is in the asset protection area. In most states, an LLC, even if it is single member LLC, insulates the assets of the LLC from creditors of the members. Because the operating agreement prohibits the transfer of a membership interest without the consent of the other members, all or creditor can do is obtain the right to receive distributions from the LLC, and not the ability to actually obtain ownership of the membership interest and participate in the governance of the LLC. This is a trap, because if the LLC is profitable, the creditor will be hit with its portion of the LLC income on its tax return, but not receive any cash distribution. In several states, unfortunately not including California, the only remedy that the judgment creditor has against the LLC member is to obtain a charging order against the interest of the member, against distributions. This protection is not available to single-member LLC in California. Therefore, if you wish to obtain the highest level of asset protection and you are a California resident, you will not own your LLC directly, but through an LLC established in another state, such as Nevada, Wyoming, Delaware, or South Dakota, which afford such protections.
Trusts and other forms of business organization
There are other forms of business organizations, since as land trusts, business trusts, and statutory trusts, which are beyond the scope of services we can offer. In addition, certain professions such as law, medicine etc. are required to use specialized entities, and if you are a member of one of these regulated professions, you’ll need to consult an attorney.
Piercing the Corporate Veil
Almost always, when a small business corporation is sued, the plaintiff alleges that the corporate entity is a mere fiction, that the corporation is merely the shareholder’s “alter ego” and that the of the plaintiff should be able to obtain a remedy from the corporate shareholder. For a corporation, this allegation will succeed if the plaintiff can show a “unity of interest between the shareholder and the corporation,” or to “prevent injustice.” The court case you can read about this is Minifie v. Rowle, (1921) 187 Cal. 481. It is not easy to pierce the corporate veil. However, that doesn’t deter attorneys from making allegation, and causing you to incur expenses in defense. On the other hand, avoiding the following practices is not only a way to avoid this happening, but are good business practices to avoid:
- Commingling funds and other assets;
- Failure to segregate funds of separate entities;
- Unauthorized diversion of corporate funds or assets to other than corporate uses;
- Treatment by an individual of the assets of the corporation as his own;
- Failure to obtain authority to issue stock or to subscribe to or issue the same;
- Holding out by an individual that he is personally liable for the debts of the corporation;
- Failure to maintain minutes or adequate corporate records;
- Confusion of the records of separate entities;
The corporate formalities described above usually involve the twin requirements that the corporation hold annual shareholders meetings and that the Board of Directors approves major decisions. Corporations which are not public companies usually don’t bother to hold formal annual meetings. But they must do so, if they want to avoid this alter ego liability. Likewise, they need to have the Board of Directors formally approve, and document that approval in writing, of major decisions of the company. These would include the election or dismissal of corporate officers, the sale of more than half of the corporation’s assets, entering into or discontinuing lines of business, and entering into major contracts. For this reason, when we set up new corporations for our clients, we include in our corporate kit a range of sample board resolutions and shareholder minutes so that you can fill in the blanks and observe these required corporate formalities.
The other main problem to avoid relates to financial matters. If a shareholder uses the corporation debit card as his personal piggy bank, or uses the corporate assets as his own, this would be an easy way for a plaintiff to show unity of interest. Instead, the corporation should transfer money to the shareholders bank account, and recorded his compensation. “Preventing injustice” is what they call an equitable remedy. It’s just the view of the judge or jury that it would be unfair to excuse a shareholder from liability because of some action he took, even though it did not arise to being fraud.
Another factor sometimes mentioned to pierce the corporate veil is under-capitalization of the enterprise. That is, an allegation that the business this type of business would normally have more capital with which to pay creditors.
One important difference between a corporation and an LLC is, for an LLC, the lack of observance of corporate for now formalities does not usually result in piercing the LLC shield of protection to the member, unless the operating agreement expressly requires holding member or manager meetings.
S Corporation Versus LLC
There are a few minor differences between S Corporations and LLCs. First, anyone can be a shareholder of an LLC. Secondly, an S Corporation can save money on payroll taxes on shareholder/employees because they can be designated to have a salary of X, on which FICA and Medicare tax (15.3% altogether) is due, leaving the remainder of their income free from such tax. LLC members may have all of their distributive income tagged for FICA and Medicare. S Corporation shareholders are also exempt from the 2.8% Medicare surtax under the Affordable Care Act. An LLC can also elect to be taxed as an S corporation and obtain these benefits by filing Form 2553 within 2 months and 15 days of its formation, or the tax year you want to be taxed as an S Corporation, as long as its shareholders are eligible to be S Corporation shareholders.