Business Counseling

Entity Selection and Formation

When a client comes to see us and is talking about starting a new business or acquiring a business, one of the most fundamental questions we deal with is the type of entity to be formed. The basic types of entities are the following: Sole proprietorship, general partnership, limited liability company and corporations (both S corporations and C corporations). (We also assist in the formation of limited partnerships; however, limited partnerships are not normally used in operating businesses but are more commonly found in investment situations such as real estate limited partnerships and the like and are sometimes appropriate for restaurants.)

SOLE PROPRIETORSHIPS AND GENERAL PARTNERSHIPS

Sole proprietorships and general partnerships are fairly simple, but they do not afford their owners any form of limited liability. Therefore, from a legal standpoint, except in specific situations, they would not normally be recommended.

LIMITED LIABILITY COMPANIES

Limited liability companies are a fairly recent creation, having been enacted in California in 1990's. The reason limited liability companies were created is that corporations, by their very nature, are quite rigid (shareholders, officers, directors) and do not reflect how a small business actually operates. Sole proprietorships and general partnerships better reflect how small business operates but, as indicated above, do not offer their owners limited liability protection. Limited liability companies, on the other hand, are a melding of the best of sole proprietorships and general partnerships, in that they have ease of operation, and the limited liability protection afforded to shareholders of a corporation.

In operating a limited liability company, the company may have officers similar to a corporation (president, vice president, secretary) but they are not required to. The company may have managers, similar to a board of directors, but is not required to. The Operating Agreement, that governs the relationship of the owners, is similar to a partnership agreement in that it generally describes how much money each of the owners are going to contribute, the relative rights and responsibilities of the owners in the functioning of the business (some may be active while others may not be) and the distribution of cash. This Operating Agreement is quite flexible and can be designed to meet virtually any business structure that the owners may want.

A comment needs to be made as to limited liability as it is commonly misunderstood. What limited liability refers to is that the owners (whether they be members of a limited liability company or shareholders in a corporation) have liability limited to the amount of capital (and perhaps loans) that they have contributed to the business. This is similar to when you purchase stock of a publicly traded company. If the company files bankruptcy, you, as a shareholder, are not are liable for the debts of the corporation. However, in a small business situation, there are many situations where an owner has liability beyond his capital contribution. This arises when owners are required to sign personal guaranties, such as for leases, vendors, and the like. Therefore, it is important that owners of either a limited liability company or a corporation understand that there are situations where their liability may exceed the amount they have contributed to the company. (In addition, there is the concept of piercing the corporate veil and alter ego where a determination is made that the owners of the corporation or limited liability company have not operated the company properly, either in that the company has been under capitalized or they have treated the company's money as their own. This topic is beyond the scope of this article, but it is something for an entity owner to be aware of.)

Another aspect of limited liability companies is that the entity does not pay a tax (other than the Gross Receipts Tax discussed further below) and all taxable items (income, loss, etc.) are passed down to the owners the same as partners in a partnership.)

Based on all of the foregoing, the limited liability company is virtually the ideal choice of entity for all small business except (and there is always an except) for one small problem: The State of California (in its infinite wisdom) decided that limited liability companies were such a perfect operating entity that owners would be willing to pay a little extra for the privilege of operating as a limited liability company. Therefore they enacted a Gross Receipts Tax on the revenue of the company. Whereas a corporation pays a tax based on its net income (gross income less deductible expenses), a limited liability company pays a tax based on its gross receipts. As of 2004, that Gross Receipts Tax is as follows:

Annual Gross Receipts Gross Receipts Tax
Less than $250,000 $800
$250,000 to $499,999 $1,700
$500,000 to $999,999 $3,300
$1,000,000 to $4,999,999 $6,800
$5,000,000 or more $12,590

CORPORATIONS

As will be seen in the discussion of S corporations and C corporations below, the decision as to whether to form as a limited liability company, S corporation or C corporation oftentimes comes down to the tax aspects since all three afford limited liability protection. Therefore, in virtually all instances, we will advise our clients to discuss this matter with their accountant as he/she is generally in a better position to advise on this. We have also learned that some accountants prefer C corporations and others prefer S corporations, while others still prefer limited liability companies. Therefore, rather than “guess” as to what our client's accountant may want, we always solicit the input of the accountant at the outset.

S CORPORATIONS AND C CORPORATIONS

A corporation is a corporation is a corporation. Many people believe that S corporations and C corporations are fundamentally different. That is not correct. All corporations are formed by the filing of articles of incorporation with the California Secretary of State, or other state if appropriate. The corporation then adopts bylaws, appoints directors and officers, issues shares and undertakes business operations. The only difference between an S corporation and a C corporation is that, in an S corporation, the shareholders file an election to be taxed under subchapter S of the Internal Revenue Code. What that election means is that the corporation does not pay tax but that the taxable items (income, loss, etc.) pass from the corporation down to the shareholders and the shareholders report that on their own individual returns similar to a partnership. In our experience, we have found that most accountants prefer that the S election be made. However, as indicated above, this is not universal as there are accountants who prefer some of the planning options available with C corporations. Therefore, this is something that should be discussed with your accountant.

For additional information contact Ross Schwartz.