A major decision facing most business owners is whether to establish their new or existing business as a legal entity. Understandably, the primary motive in considering a formal legal entity is avoiding personal liability for the obligations and debts of the business. Business owners usually realize that losses sustained by the business may wipe out the amount invested in the business, but the real concern is whether creditors of the business can reach the business owner's personal resources beyond the amount invested in the business, if the business assets prove insufficient.
Other motivations in considering a formal legal entity may include obtaining favorable tax treatment, creating a vehicle to facilitate capitalization of the company, and establishing a formal organization structure to assist in the maintenance and operation of the company.
With the availability of a myriad of business entities, the business owner may be overwhelmed with the various choices which include the following: "C" Corporation, "S" Corporation, General Partnership, Limited Partnership, Limited Liability Company, Professional Corporation, Limited Liability Partnership, and the Sole Proprietorship.
Although an extensive analysis and discussion of the various business entities falls outside the scope of this article, the following does present a brief discussion of the various entities available, as well as some of their objectives, benefits and disadvantages.
A corporation is a separate legal entity existing under authority granted by state law. It has its own identity, separate and apart from its shareholders. As such, all income of the corporation is taxed at the corporate income tax rate. Subsequently, if company profits are distributed to shareholders in the form of dividends, they are again taxed at the receiving shareholder's individual income tax rate. Hence the term "double taxation."
Corporations are formed, among other things, to shield shareholders from personal liability for the corporation's activities. Creditors may look to the assets of the corporation for payment, but may not look to the shareholders' personal assets for payment.
However, the corporation must act like a corporation in order to qualify for the legal protection and tax advantages the corporate form offers. Unless all corporate formalities and requirements are adhered to (e.g., holding of shareholder and board of director meetings), the shareholders may be held personally liable for the corporation's debts and liabilities under the "alter ego" theory of liability (i.e., the corporate veil may be "pierced").
Comparison of the "C" and "S" Corporation
"C" and "S" corporations are two particular forms of corporations that are prevalent in California. Both "C" corporations and "S" corporations are entities having the advantages of corporate form. Both enjoy centralized management and control through a board of directors elected by shareholders, privacy and anonymity of shareholder identities, as well as insulation of shareholders from personal liability.
The primary difference between "C" and "S" corporations involves income tax treatment. For income tax purposes, the "S" corporation is analogous to a sole proprietorship or partnership, and consequently, each item of income and expense is "passed through" directly to shareholders and not taxed at all at the corporate level. This allows owners of companies to take advantage of the corporate form and accompanying limited personal liability, but does not subject them to the double-taxation of corporate profits. As you can see, the "S" corporation is an attractive device for those business owners who want to distribute the majority of the corporation's net profits. However, because the tax rate for individuals with large incomes is generally greater than the highest corporate tax rate, shareholders of a corporation with extremely high profits could pay more to operate in an "S" form than in a "C" form.
The General Partnership
A general partnership is a form of business entity in which two or more co-owners engage in business for profit. No specific formalities are required to form a general partnership. Although a general partnership has some of the attributes of a separate legal entity, general partners remain personally liable for the partnership's obligations, and partnership income or loss is once again "passed-through" to the partners.
The Limited Partnership
A limited partnership is very similar to a general partnership. The difference is that a limited partnership is comprised of one or more "general partners" who manage the business, and one or more "limited partners" who contribute capital and share in the profits, but who normally take no part in running the business.
As in a general partnership, general partners remain liable for partnership debts and obligations. However, limited partners incur no liability with respect to partnership obligations beyond his or her capital contribution. The purpose of this form is obviously to encourage passive investors to invest in the enterprise by allowing them to reap a share of the profits if it succeeds without risking more than the capital contributed.
The Limited Liability Company
A limited liability company ("LLC") is a relatively new form of legal entity in California that provides a shield for personal liability of the owners (called "members") while permitting the "pass through" tax advantages of a partnership or sole proprietorship. The primary benefit associated with the LLC is its flexibility. For example, an LLC can be operated either by its members/owners (similar to a partnership) or by appointed managers (similar to a board of directors). The LLC also has the added benefit that there is no "alter ego" theory of liability based on the shareholder's failure to hold meetings or observe other "corporate formalities."
The Professional Corporation
Certain licensed, professional activities can be conducted in the corporate form including the practice of law, medicine, dentistry, and accountancy. In general, a professional corporation is formed in the same manner as a "C" corporation and is subject to the same general requirements. However, because there are a variety of additional requirements due to the highly regulated nature of the aforementioned professions, an attorney should always be consulted when determining whether a professional corporation is the appropriate vehicle for your business.
The Limited Liability Partnership
In California, the limited liability partnership ("LLP") is typically available only to partnerships engaged in the practice of law or accountancy. Moreover, all partners of the law or accounting firm must be licensed to practice in their respective professions. In general, an LLP is a general partnership with the added feature of a corporate-style limited liability shield for its partners.
The Sole Proprietorship
Finally, the sole proprietorship is the simplest form in which to conduct business. A sole proprietorship is not a legal entity itself. Rather, the term refers to a natural person who directly owns the business and is directly responsible for its debts and obligations.
Gregory G. Brown, Certified Trial Specialist
Brown & Charbonneau, LLP