Posted On: July 2, 2012 by Mitchell A. Port

Business Entities

When beginning a business in California, you must decide what form of business structure to create. For federal tax reporting purposes, your form of business determines which income tax return form you have to file with the IRS. The most common forms of business are the sole proprietorship, partnership, corporation, and S corporation. Tax and legal considerations enter into selecting a business structure.

LLCs - limited liability companies - are also available in California. The federal government does not recognize an LLC as a classification for federal tax purposes. An LLC business entity must file a corporation, partnership or sole proprietorship tax return. A Limited Liability Company (LLC) is a business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.

A California LLC generally offers liability protection similar to that of a corporation but is taxed differently. Domestic LLCs may be managed by one or more managers or one or more members. In addition to filing the applicable documents with the Secretary of State, an operating agreement among the members as to the affairs of the LLC and the conduct of its business is required. The LLC does not file the operating agreement with the Secretary of State but maintains it at the office where the LLC’s records are kept.

A sole proprietor is someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.

A California general partnership must have two or more persons engaged in a business for profit. Except as otherwise provided by law, all partners are liable jointly and severally for all obligations of the partnership unless agreed by the claimant. Profits are taxed as personal income for the partners. A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.

A California limited partnership (LP) may provide limited liability for some partners. There must be at least one general partner that acts as the controlling partner and one limited partner whose liability is normally limited to the amount of control or participation of the limited partner. General partners of an LP have unlimited personal liability for the LP’s debts and obligations.

S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income.

To qualify for S corporation status, the corporation must meet various requirements.

A California corporation generally is a legal entity which exists separately from its owners. While normally limiting the owners from personal liability, taxes are levied on the corporation as well as on the shareholders. The sale of stocks or bonds can generate additional capital and the longevity of the corporation can continue past the death of the owners. Legal Counsel should be consulted regarding the variety of options available.

To form a corporation in California, Articles of Incorporation must be filed with the California Secretary of State’s office.

Effective January 1, 2012, there are two new subtypes of stock corporations in California — a "flexible purpose corporation" and a "benefit corporation." The new corporation subtypes allow entrepreneurs and investors to organize stock corporations that can pursue both economic and social objectives.

In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.

The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.

Useful links on this topic include:

Business Structures

Starting a Business - Entity Types

Call business attorney Mitchell A. Port to form a new entity.