After a business owner develops a business that lays out what a business intends to become, they will need to think about the legal structure for their venture. It will be important to know where a business will be headed, answering questions about whether a business owner plans to work alone, plans to add employees, hopes to eventually become a corporation, and what a corporation would look like.
Business owners must also consider many tax, legal, and compliance considerations that can require the help of an experienced small business lawyer. People trying to sort through the many legal entities a business can form under will want to consult with their certified public accountant (CPA), who will usually be able to discuss options and plans for the future of a business but will probably refer them to an attorney.
Picking a Business Structure
The California Office of the Small Business Advocate publishes a helpful list of information about choosing a business structure and registering a business that includes state, federal, and local requirements. There are several different kinds of business structures, each having its own advantages and disadvantages.
Sole Proprietorship
Probably the simplest and also the least expensive business structure. While there are certain costs in obtaining a business name registration and other licenses, the attorney fees should still be minimal since there will be less documents to prepare than in other structures. With a sole proprietorship, a small business owner will retain complete control over all business decisions. A small business will automatically be considered a sole proprietorship if it partakes in business activities but does not register as any other kind of business. Sole proprietorships will not be a separate business entity, meaning business assets and liabilities will not be separate from personal assets and liabilities, so small business owners can be personally liable for debts and obligations of the business. Sole proprietors cannot sell stock, and many banks will be hesitant to lend to sole proprietorships. These may be a good choice for low-risk businesses and owners who want to test business ideas before forming more formal businesses.
Partnership
Partnerships may be general partnerships (GPs) that result in no entity income tax and allow all partners to be involved in management decisions or limited partnerships (LPs) or limited liability partnerships (LLPs), which are more suitable for investors who want limited liability and are willing to give up the right to participate in management. Any partnership needs to be backed up by a legal agreement drawn by an attorney, and legal fees involved in forming a partnership will be higher than fees for sole proprietorships but will usually be less than the fees for incorporation. In a partnership, every partner will be responsible for the other partner’s actions as well as their own. LPs will have a single general partner with unlimited liability while all other partners have limited liability and more limited control over the company, usually documented in the partnership agreement. LLPs are similar to LPs, but offer limited liability to all owners and protect each partner from debts against the partnership so they will not be responsible for the actions of other partners. Partnerships may be a good choice for businesses with multiple owners, professional groups, or other groups wanting to test ideas before forming more formal businesses.
Limited Liability Company (LLC)
LLCs let business owners take advantage of the benefits of both the corporation and partnership business structures while protecting them from personal liability in most instances so personal assets will not be at risk in case the LLC faces bankruptcy or lawsuits. Profits and losses will be passed through to personal income without corporate taxes, but members of LLCs are considered self-employed and have to pay self-employment tax contributions towards Medicare and Social Security. LLCs may have limited lifetimes in certain states, as a member joining or leaving an LLC could require the LLC to be dissolved and re-formed with new membership unless there is already an agreement in place within the LLC for buying, selling, and transferring ownership. LLCs may be a good choice for medium- or higher-risk businesses, owners with significant personal assets they want protected, or business owners who want to pay a lower tax rate than they would with a corporation.
Corporation
There are actually five different corporation structures:
- C corp — A corporation is often called a C corp and is a legal entity separate from the owners. Corporations can make profits, be taxed, and be held legally liable. Corporations will offer the strongest protection to owners from personal liability, but the cost to form a corporation can be much higher than other structures. Corporations will also require more extensive record-keeping, operational processes, and reporting. Unlike sole proprietors, partnerships, or LLCs, corporations have to pay income tax on profits. Some corporate profits may be taxed twice—first, when a company turns a profit, and again when dividends have to be paid to shareholders on personal tax returns. Corporations will have a completely independent life separate from shareholders, so a shareholder who leaves a company or sells their shares will mean the C corp can continue doing business without disruption.
- S corp — An S corp is a special kind of corporation designed to avoid double taxation drawbacks of regular C corps. S corps will allow profits and certain losses to be passed through directly to an owner’s personal income without being subject to corporate tax rates. Not every state taxes S corps equally, but most will recognize them the same way the federal government does and tax shareholders accordingly. Some states tax S corps on profits above specified limits and other states will not recognize S corp elections at all. S corps have to file with the Internal Revenue Service (IRS) to get S corp status.
- B corp — Also known as a benefit corporation, a B corp is a for-profit corporation recognized by most states in the nation. B corps will be different from C corps in their purpose, accountability, and transparency, but will not be different in how they are taxed. B corps are driven by both their missions and profits. Shareholders can hold a company accountable to produce some kind of public benefit in addition to profits, and certain states require B corps to submit annual benefit reports demonstrating their contribution to the public good.
- Close corporation — Close corporations are similar to B corps but involve a less traditional corporate structure. While state rules can vary, shares will usually be barred from public trading. Close corporations are often run by a small group of shareholders without a board of directors.
- Nonprofit corporation — Nonprofit corporations are intended to do charity, education, religious, literary, or scientific work. Since their work benefits the public, nonprofits may receive tax-exempt status, meaning they will not pay state or federal income taxes on any profits they make. Nonprofits have to file with the IRS to get tax exemption, a different process from registering with their state. Nonprofit corporations also need to follow organizational rules similar to traditional C corps as well as special rules about what they do with any profits they earn. Nonprofits are often called 501(c)(3) corporations.
Speak with an Experienced Mountain View Small Business Attorney
Kalia Law P.C. has helped scores of small businesses all over California find the right business structure for their needs. Our firm can assist with many different kinds of contracts and agreements.
We know that many documents are available for people to download online and use for business purposes, but it can be confusing for a small business owner to navigate the right ones to use. You can call (650) 701-7617 or contact us online to receive an initial appointment.
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