FORMATION & BUSINESS PLANNING
Choosing the appropriate business entity for your company is one of the more important decisions to be made along the road to success. Each type of business organization is governed by different legal rules and decisions which can affect the entity and its owners far into the future. New businesses must consider start-up expenses, the complexity of the possible business forms, personal liability issues, tax consequences, and the continuing legal burden imposed by statutes and regulations. Most businesses choose from among the following forms:
Sole Proprietorships combine ownership and management in one person. The owner receives business profits (and losses) directly, with income taxed on the owner’s personal return and not at the business level. Sole proprietors hold complete and personal liability for business obligations. While this form requires no statutory establishment (owners can just start business at any time), they must obtain any needed licenses and obey employment laws.
General Partnerships involve two or more owners operating a business for profit. As with a sole proprietorship, the partners generally hold personal liability for business obligations, and receive profits directly from the business as income. This tax advantage makes partnerships very attractive to some business people.
Limited Partnerships consist of one or more general partners and one or more limited partners. The most important feature of a limited partnership is that the limited partners are granted limited liability as long as they follow certain guidelines such as not participating in the control of partnership business. The liability of the limited partner is thus limited to the extent of the limited partner’s investment. The limited partnership is managed by its general partners. A limited partnership may engage in the same sort of business as a general partnership, except a limited partnership may not engage in banking, insurance, or trust company business.
Corporations become separate legal entities upon formation. As such, corporations assume liability for their own obligations, thereby insulating the owners, directors, and officers of the business from personal responsibility. Additionally, corporations can sell ownership interests, or shares, in the company to raise capital. Despite these benefits, the tax treatment of a corporation can cause financial obstacles. A corporation can be organized as a “C” corporation or an “S” corporation.
C Corporations have no shareholder restrictions; however, “C” corporation earnings are subject to double taxation. The corporation is first taxed on its income, and then the shareholders are also taxed when they receive that income as dividends.
S Corporations have restrictions on the type and number of shareholders, as well as restrictions on the types of stock offered. They are however, subject to only one level of taxation. All corporate earnings “pass through” the corporation to the shareholders and the earnings are treated as income of the shareholders for tax purposes. Because of the special tax advantages of S corporations, the number of S corporations has increased rapidly in the last 20 years. In fact, S Corporations are now the most common corporate entity accounting for 59% of all corporations in 2002.
Limited Liability Companies pose another option for new businesses. These organizations combine some of the tax benefits of partnerships with aspects of corporate limited liability. While this combination is compelling, limited liability companies must comply with specific ownership and termination requirements and may not realize the full extent of either the tax or liability advantages. Furthermore, even though properly formed limited liability companies pay no income tax on their profits, the State of California taxes the gross receipts of limited liability companies. The gross receipt tax is relatively modest for small companies. However, if a company’s gross receipts will regularly exceed $1,000,000.00 per year, another entity choice may be superior.
Occasionally people confuse a specialized entity known as a Limited Liability Partnership with a limited liability company. However, in California, a limited liability partnership is only available for licensed accountants, architects, and lawyers. A limited liability partnership is taxed as a partnership, but, if the business provides adequate assurance that its clients will be compensated for professional negligence through insurance and other means, the owners of the business will generally avoid personal liability for any business liabilities.