When starting a business, the first issue (other than the name of the business) facing the owner is what type of business entity he or she should choose. The most common forms of business entities in California are Corporation (C, S, and Non-profit Corporation), Limited Liability Company (LLC), Partnership and Sole proprietorship.
Corporation
Corporations need to file Articles of Incorporation with the Secretary of State of California. They normally issue stocks (whether common stocks or preferred stocks) to their shareholders to ascertain their ownership and rights as owners of the company. The most popular types of corporations used in the US are the “C” Corporation, “S” Corporation and Non-profit Corporation (Public or Mutual Non-profit Corporation).
C-Corporation is the most commonly used type of corporations. C-Corporations can have any number of shareholders. Shareholder’s assets protected from the creditors of the corporation since the liability of the shareholders is limited to the amount contributed by them to the capital of the Corporation.
One disadvantage of C-Corporations is double taxation as profits are taxed first as income to the corporation, then as income to the shareholder when distributed as dividends or profit sharing. Small corporations having no more than 75 shareholders (who are not themselves corporations) can obtain S-Corporation status. If a corporation has S-Corporation status, the corporations are not separately taxable entities, so the income and loss are “passed-through” to the shareholders.
In cases where business activities of the Corporation are education, charity, or scientific activity there is an opportunity to establish a Non-Profit Corporation through filing applications with the Internal Revenue Services and California Franchise Tax Board. Net profit of such corporation is not subject to taxes if it is destined for corporate purposes and is not allocated between the shareholders, directors or other officers.
Limited Liability Company
Limited liability company (LLC) combines the corporate advantages of limited liability with the partnership advantage of pass-through taxation. The members of an LLC can be managers of the company not exposing to risks their personal assets. Limited Liability Companies are taxed on the level of its members like Partnerships. Profit and loss distribution does not have to be allocated according to the ownership percentage, but rather, according to an Operating Agreement amongst the members. LLC does not issue stock to its members.
The main difference between an LLC and an S-Corporation is that all profits, liabilities, losses and deductions of S-corporation are divided between the owners in proportion to the number of shares held by them. An LLC is more flexible as to the division of these items between the owners. Profits of the S-Corp which pass through to the shareholders are not subject to self-employment tax (Social Security and Medicare which is approximately 15%). Rather, self-employment is only taxed on the portion classified as a “reasonable salary”. LLCs and sole-proprietorships must pay self-employment tax on all income. The ability to minimize self-employment tax is deemed to be one of the greatest benefits of a S-corporation.
Partnership
The simplest type of partnership is a Sole Partnership. A Sole Partnership is a business entity connected with the sole owner. In this case the owner runs the business on his own behalf.
A General Partnership is a form of business organized by two or more individuals who do not want to set up a Corporation or other type of company. In this case the members are responsible for any debts and liabilities in proportion to their stake in share capital of the Partnership. In the same way they participate in the distribution of profits.
In the case of a General Partnership, only the income of the members is subject to taxes.
In a Limited Partnership the assets and liabilities are divided between general and limited partners. Thus, limited partners in contrast to general members are liable for the debts and liabilities of the Partnership only to the amount of their stakes in the partnership’s capital.
In a Limited Liability Partnership the assets of each partner are more secured. This is due to the fact that the members of a Limited Liability Partnership do not bear responsibility for any debts or liabilities that have been caused by improper or invalid acts of the other members, officers or agents of the Partnership. In all other cases the members of the Partnership are liable for all debts and liabilities of the Partnership as well as for all debts and liabilities that have been caused by acts committed by any officer subordinated directly or managed by the partners.
Sole Proprietorship
A sole proprietorship is a one-person business that is not registered with the state as a corporation or a limited liability company (LLC).
Sole proprietorships are so easy to set up and maintain that you may already own one without knowing it. For instance, if you are a freelance photographer or writer, a craftsperson who takes jobs on a contract basis, a salesperson who receives only commissions, or an independent contractor who isn’t on an employer’s regular payroll, you are automatically a sole proprietor.
However, even though a sole proprietorship does not afford any protection against personal liability as the owners are personally responsible for paying both income taxes and business debts.
