Business Formation: Choosing the Right Entity for Your Bay Area Company

Sole Proprietorship, Partnership, LLC & Corporations

There are many different ways to legally structure your business.

The most common business formation is a sole proprietorship. It means that one person owns the business and you do not have to file any papers with the state to own or operate the business. If you want to use a name other than your own, you will need to file a fictitious business name statement with your local government to show who owns the business. Most cities and counties also require you to register your business and get a business license. All banks and some landlords require a business license in order to open a business bank account.

The other non-entity option to structure your business is a partnership. It is the same type of business formation as a sole proprietorship except it has more than one owner.

Business Entities

A business entity is something that is separate from you personally. The two main entities for your business are either a corporation or a limited liability company. An entity has owners and is the legal structure for operating the business.

Business entities have to file a Statement of Information with the California Secretary of State and pay a filing fee. There is an $800 minimum tax (even if you don't make any money) and an annual filing fee.

1. Limitation of personal liability
2. Ability to share ownership of the business with others
3. Ability to get funding from investors
4. Potential flexibility with employee requirements

Without an entity, there is no limitation of personal liability. As the owner, your personal assets are at risk. A major benefit is the protection that a separate entity offers for your personal assets for an injury or some other happenstance.

Having an entity makes it easier to share ownership of the business. You can create and structure your own unique ownership structure of a business entity. For example, you can create classes of ownership with different rights. Also, you can use corporate shares to compensate your employees by giving them an ownership interest.

Depending on what type of entity you choose, there are different names for the ownership interests. For instance, for corporations, owners receive and hold stock. For an LLC, the owners are called members who receive memberships or units.

LLCs have more flexibility with meeting the requirements for employees. Under the LLC business structure, all of the people who work for the LLC are also owners. They are not considered employees, and therefore they are not subject to the employment requirements under California law.

There are requirements when you create a business entity. You have to always remember that the entity is separate from you as a person. When you sign or create any business document, the document and your signature need to be in the name of the entity, not you as an individual.

You have to create, read and maintain the appropriate legal documents in a safe place.

Corporations require you to have an annual meeting, give the required notice and keep minutes of the meeting. You must also identify an agent for service of process.

Even if you only have one owner, you still must document the corporate actions. You may need an accountant or a bookkeeper that knows how to do the correct accounting for your entity type. You will need to keep your personal finances completely separate from the business accounts.

The choice of entity usually depends on the tax status that works best for you and your business. Corporations can be taxed under IRS Subchapter C or Subchapter S. An LLC can be taxed under Subchapter C, Subchapter S or Subchapter K. When choosing what type of entity you want to have, you should always consult with a tax professional.

Investors will usually require an entity business formation to invest any money.

The requirements for LLCs vs. corporations are very different. An LLC is not a corporation and does not require a board of directors, officers or meetings so it is easier to observe the formalities of having a separate entity. LLCs have more choices for how the entity is taxed - 3 options v. 2. LLCs also have more flexibility under California's strict employment laws for how you pay and insure your employees. The law gives you more flexibility in how you set up your entity. LLCs are required to pay state taxes on gross receipts according to the amount of income, but it may still be more beneficial to have an LLC than not.

Corporations require a Board of Directors, corporate officers and shareholder meetings are required. There are fewer options for tax status and it is more standardized in terms of the formal requirements. Corporations are generally more burdensome when there is only one person operating the corporation. Even with one owner, you must still observe all of the formalities.

A LLC or a corporation formed under Subchapter S tends to pay less taxes. S corporations are a popular choice for small businesses. Profits are passed through to the owner and taxed only at the owner level. If the corporation does not pay the profit to the owner but reinvests the profits, the owner is still liable for taxes on that income which is often referred to as "phantom income." This problem of phantom income can happen with either Subchapter S or Subchapter K but not under Subchapter C.

An S corporation has limitations on its business formation requirements. Only individuals, US citizens or permanent residents can be owners of an S Corp. No entities are allowed to own an S Corp. There is a maximum cap of 100 on the number of owners, and all owners have the same economic rights. An S Corp. cannot have more than one class of stock with the exception of voting rights. Worker-owners are considered employees and subject to employment tax and the requirements of California's employment laws.

Subchapter C or a "C Corp" creates what is known as a "double tax." This means that the entity must pay taxes on any income and that same income is taxed again when distributed to the owners. Under all three subchapters, any salary or draws paid to the owner are subject to employment tax. Still, anyone can be an owner of a C Corp. In a C Corp., worker-owners are considered employees and subject to employment tax and the requirements of California's employment laws whereas if the LLC is set up under Subchapter K, the worker-owners are not considered employees.

If an LLC is formed with only one member, it does not have any tax status. Any income from the LLC is reported on your personal income tax return on Schedule C. The most beneficial practice is to make quarterly estimated payments for income and self-employment tax to avoid penalties and interest.

Bay Area business owners have lots of choices how to set up their business. Choosing the right one means you need to weigh the pros and cons of each type of entity against your personal goals. What to choose depends on your personal goals and preferences and what you imagine the future holds for you.