Choosing a Business Structure that Fits - What’s right for you?

By Joe Utzurrum, Esq.

What’s in a business name? Is it more advantageous to sell widgets as Smith, Inc., Smith, LLC or just plain old Bill Smith? Choosing the appropriate business structure can be as daunting as solving the problem of how to drive customers to the store front door in a new age where this is more likely executed by creating code for a phone app rather than freehand sketching possibilities for the front window display.

The likely short-term question is, “What structure would result in the easiest and fastest way to get a product or service to market?” To most the preferred answer is a choice that involves the lowest fees and the least amount of paperwork. However, what might seem to be the easiest and fastest route to start a business might not be the most efficient and probably not the most profitable in the long run. A business owner’s personal assets need to be factored in so that if an unplanned event like a lawsuit by a past or potential customer or claim by a competitor occurs, the owner’s personal assets will be out of reach from creditors. The business should to be set up so that if something does go wrong, Bill Smith the family man is considered separate from Bill Smith the business owner.

            While there are many factors to discuss that fall beyond this brief overview, it might be helpful to discuss the general pros and cons of each business form and the initial and recurring obligations required to maintain each structure. Although the main focus will be the legal aspects of each form, general tax issues will be discussed. Nevertheless state and federal tax codes are complicated. It is always best to spend a few dollars to consult with an accountant to get perspectives on the tax consequences of each entity type in relation to the specifics of the startup business. A decision about the form of business chosen would then become a decision that is well informed.

Sole Proprietorship

Most start a business by setting up shop close to home, for instance the garage, the living room or dining room, then using a surname combined with the product or service being offered to the public, for example “Bill Smith Widgets” and “Jane Doe Dog Walkers”. Most like to keep it simple. No specific filing needs to be made to create a sole proprietorship, because the business form is not considered a separate legal entity with its own separate rights and liabilities. Even so, this does not mean that documents do not need to be submitted to various state and local agencies. In fact, although a sole proprietorship may be the least complicated to create, the owner may need to notify certain agencies that she is conducting business in a certain manner and at a certain location, because failing to do so might expose her to penalties when the agencies are later notified from third parties, for example, customers and vendors.

In the case where the business owner’s last name (surname) is used in the name of the business, there is generally no need to file for a fictitious business name with the County Clerk’s Office. A fictitious business name is commonly referred to as a “dba” (short for “doing business as”.) If the name of the business (1) does not incorporate the surname of the owner; or (2) suggests the existence of additional owners, for example “ACME Dog Walkers” or “Jones & Sons”, then California state and local law require the filing of a fictitious business name statement with the County Clerk’s Office in the counties that the business transacts business within forty days of commencing the transacting of business.[1] Thirty days after filing the fictitious business name statement, the statement must be published in a newspaper of general circulation in the county where the business is being conducted for four consecutive weeks.[2] While the filing fee of the statement is not substantial, $26.00, and lasts five years at which time the statement must be renewed, it is the publication of the fictitious business name statement that can put a dent in an owner’s wallet.

Why file? The filing of any fictitious business name statement by a person required to file the statement shall establish a rebuttable presumption that the registrant has the exclusive right to use the fictitious business name as a trade name, as well as any confusingly similar trade name, in the county where the statement is filed, as long as the registrant is the first to file such a statement containing the fictitious business name in that county, and is actually engaged in a trade or business utilizing such fictitious business name or a confusingly similar name in that county.[3] Take for instance, the case of the owner of a pizzeria, Cary Cheese. As long as Cary timely filed his fictitious business name “Pizzeria Express” with the county clerk and as long as Cary was the first to file and first to use the name in the county, Cary would be presumed to have the exclusive right to use the name over all others including those who sold pizza using a confusingly similar name, for example “Pizza Exprezz” or “Pizzeria Espresso” and the like. If Cary’s pizza shop became popular and financially successful, there would be added value to his business because of the value attached to the business name.

Starting a sole proprietorship is relatively inexpensive if it is unnecessary to file a fictitious business name statement. Of course an owner needs to determine if a County and/or a City business license is needed. Not all businesses must apply for licenses to operate in unincorporated areas of the County. Generally, a business is required to be licensed if it is subject to County health or safety regulations. County websites, including Los Angeles County, usually have a list of the types of businesses that require licenses.

Additionally, all individuals or entities conducting business activities within the City of Los Angeles are required to apply for and obtain a Business Tax Registration Certificate with the City of Los Angeles, Office of Finance. As a business operating within the City of Los Angeles, applicable taxes may need to be paid. All businesses are required to file an annual tax renewal regardless of whether or not the business generated revenue for that tax year. Filing the renewals timely avoids late penalties and fees and also ensures the ability to take advantage of all available tax credits and incentives. Business tax exemptions, such as New Business, Small Business with global gross receipts less than $100,000, and Creative Artist require the timely filing of renewals to qualify for the exemptions.

Certain owners must also obtain a sellers permit from the State Board of Equalization if the owner is engaged in business in the State of California and the owner intends to sell or lease tangible personal property that would ordinarily be subject to sales tax if sold at retail. If an owner intends to only sell or lease tangible personal property for ninety (90) days or less, for example seasonal goods, then the owner must obtain a temporary sellers permit.

As a sole proprietor, the owner may be liable to others who are adversely affected from the business. That is to say, the business owner has unlimited personal liability for losses. There is no protective wall between personal assets and business assets. Community property can be used to satisfy either spouse’s contractual obligations incurred before and during the marriage, including obligations of spouses in registered domestic partnerships.[4] Some protection can be obtained by purchasing business insurance. However, the kind of transactions involved and the limits of liability will affect the cost of the insurance. Business owners are recommended to discuss the potential liability and potential loss that exist with an attorney to help determine the amount of insurance to purchase and if the purchase of insurance would adequately protect personal assets.

It is important to consider the tax implications of transacting business as a sole proprietor because a sole proprietor will report the profits and losses of the business to the Internal Revenue Service (IRS) by filing a Schedule C along with Form 1040. Legitimate business expenses can be deducted from a sole proprietor’s taxable income but generally they are less advantageous than other business forms. “The net profits (income less deductions) of a sole proprietorship business are taxable each year to the owner. Amounts withdrawn by the sole proprietor for personal use (whether denominated ‘salary’ or otherwise) are not deductions for tax purposes. The net profits from the business are simply included with any other income of the proprietor on his or her personal income tax return, and are taxed accordingly.”[5]

Partnership

The same issues in the sole proprietorship apply to the partnership, i.e., (1) filing a fictitious business name in the counties where the business is transacting business; (2) obtaining a business license with the counties and cities where the business is transacting business; and (3) obtaining a seller’s permit. A partnership is a from of doing business that occurs when two or more co-owners engage in business for profit whether or not the persons intend to form a partnership.[6] The partners together own the assets and are personally liable for all business debts. In the case of a General Partnership, this means that claims can be made against one, any, or all of the general partners. In Limited Partnerships it is possible to limit the liability of certain passive partners under certain conditions.

If there is no express agreement among the partners, profits and losses are shared equally by all. An agreement may be made that certain partners are allocated a greater amount of profit than others or have the obligation to pay a larger or lesser amount of the partnership liabilities. Despite an agreement, personal liability is unlimited for each general partner, particularly each partner is jointly and severally liable to the partnership creditors. Take the case of Cary Cheese who entered into a general partnership with his daughter Carly Cheese who is a brain surgeon. If a customer slips on cheese at the pizzeria is injured and later obtains a judgment against them, the customer has the choice of pursuing the assets of both Cary and Carly to satisfy the judgment or only pursue the assets of Carly.

Each partner is an agent of the partnership when dealing with third parties in the ordinary course of the partnership’s affairs and can bind the partnership to contracts that are within the scope of the business. There is a limit on this ability of one partner to bind the partnership, that is, the other partners. When a third party knows that the partner is acting outside the scope of his/her authority in making an agreement, then the other partners are not liable for liability arising out of the unauthorized agreement.[7]

A partner’s personal assets are not protected from the tortious acts of another partner. Each partner is jointly and severally liable for the acts of the other partners committed (1) within the authority of the partnership agreement, including those that are express and implied; and (2) within in the ordinary course of the business.[8] The unlimited liability exists whether or not the partners have an agreement to disproportionately share in the profits, losses and payment of liabilities of the partnership, that is, the partners’ agreement to limit the other partners’ liability from third party tort claims are not enforceable against the third party, although such agreements might give rise to indemnity rights between partners.

Absent an agreement, general partners have the same rights to participate in the management and control of the business. Disagreements are settled by the majority of the partners, if there is no agreement to the contrary. No express written or oral agreement is needed to form a partnership. In fact, the partnership may be implied by words or conduct. As long as at least two persons agree to carry on a business for profit, a general partnership is formed. After the partnership is formed, partners have fiduciary duties to other partners, including prohibitions against self-dealing and conflicts of interest, and must be discharged consistently with the obligations of good faith and fair dealing.[9]     Although there are other ways that a partnership can dissolve, depending on the type of partnership, generally a partnership is dissolved when half of the partners express an intent, through words or action, to dissolve and wind up the partnership.[10] For example, if in a two-person partnership, which is the usual scenario, one person withdraws from the partnership, the partnership is automatically dissolved. After the partnership is dissolved the partners would then have rights and duties as to the partnership assets and obligations.

Limited Partnership

Limited partnerships are similar to general partnerships. There exists only one formality in forming a limited partnership, the filing of a certificate of limited partnership with the Secretary of State along with the payment of associated filing fees.

Limited partners have limited liability in the partnership’s financial obligations, i.e., liability is limited to investment/capital contribution. The limited partner cannot take part in business operations relating to control of the business and must be passive investors. A limited partner is not liable for any obligation of a limited partnership unless (1) named as a general partner, or (2) in addition to exercising the rights and powers of a limited partner, the limited partner also participates in the control of the business. If a limited partner participates in the control of the business the limited partner may be held liable just as a general partner to those persons who transact business with the limited partnership with actual knowledge of that limited partner’s participation and also reasonably believes that the limited partner is a general partner.[11] The general partners are open to the same joint and several liability as partners in a general partnership. A layer of protection can be added further limiting liability by making the general partner a corporation.

A partnership does not pay taxes, whether general or limited. A partnership files an informational return, Form 1065 with the IRS, indicating the income, expenses and the distributions to each partner that are usually established in the partnership agreement.[12] It is said that the profits and losses of partnership are “passed through” to the partners, meaning that the distributive proportionate share of the profits and losses of the business are attributed to the partner’s personal return, whether or not the profits and losses are actually distributed to the partner.[13] From a practical matter partners usually want the profit to be actually distributed to him/her so that the partner can cover his/her personal tax liability, in other words, instead of the partnership/business retaining the profit for reinvestment, partners usually want the profit distributed because the partners need it to pay their tax liability to the IRS and state tax agencies. Losses are passed through to the partners in the same manner and can be used to offset income made from other sources. In California, limited partnerships must pay a minimum annual franchise tax of $800.00.

Corporation

A corporation, sometimes referred to as a “C Corporation”, is considered a separate legal entity and is formed by the filing of Articles of Incorporation by the Secretary of State. The law generally treats a corporation as a separate “person”, i.e., separate from its shareholders. A corporation can execute contracts, has its own separate and distinct obligation under the Tax Code, can be liable for torts committed against others and can also be found to have committed crimes.

The corporation alone is liable for its debts. Except for extraordinary circumstances, its shareholders (owners of the corporation), directors and officers are shielded from the corporate financial obligations. That is to say, shareholder losses are limited to their capital investment, or limited to what the shareholder invested to capitalize the corporation. The “limited liability” of a corporation’s owners, or its shareholders, is a key feature of the corporate form.

For instance, if Pizzeria, Inc. is found by a court to be liable to Simon Slippy for injuries Mr. Slippy suffered when he tripped over a single slice of mozzarella cheese in the shop and is ordered to pay Mr. Slippy one million dollars in damages. Mr. Slippy can only satisfy the judgment by looking to Pizzeria, Inc’s assets and not those of its most involved owner, Cary Cheese. Mr. Slippy cannot pursue the home that Cary outright owns, his IRA or his bank accounts and further will not be successful in attempting to garnish the wages of the two other shareholders, Cary’s son, Charlie Cheese, who works part-time after school at the store or the wages of his daughter Carly Cheese, who is a brain surgeon living in a mansion in Brentwood. If the judgment exhausts Pizzeria, Inc.’s assets, Cary, Charlie and Carly would only lose the money that they invested in Pizzeria, Inc.

There are conditions that may exist to allow Mr. Slippy to “pierce the corporate veil” of Pizzeria, Inc. and break through the protective wall that a corporation provides between creditors on the one side and shareholders, directors and officers on the other side. No one factor is determinative of whether the veil can be pierced. Factors considered are  (1) whether the corporation is an “alter-ego” of the shareholders that would take into consideration whether or not the corporation observed required corporate “formalities”, for instance holding annual meetings of shareholders to elect the board, holding annual meetings of the board of directors to adopt bylaws and appoint officers, keeping minutes of meetings, issuing shares, paying taxes, etc.; (2) whether shareholder personal funds were commingled with corporate funds; (3) whether corporate funds were misused; (4) whether the corporation was undercapitalized; (5) whether the corporation was established to defraud others, inter alia.

Additionally, if shareholders of a corporation personally participated in wrongdoing, those shareholders can be held personally liable to others. The act constituting the wrongdoing however cannot be of the kind that the shareholder as an employee of the corporation, board member or officer performed within the course and scope of his/her duties as an employee, board member or officer of the corporation. In the above scenario, if Charley in performing his duties as an employee failed to sweep the cheese that Mr. Slippy tripped on, Cary would probably not be held personally liable to satisfy Mr. Slippy’s judgment. On the other hand, if Cary intentionally placed the cheese on the shop floor that Mr. Slippy tripped on for the purpose of getting a laugh, Cary would probably be held liable for Mr. Slippy’s judgment, although Cary is a shareholder of Pizzeria, Inc.

Although the veil does exist, many creditors that transact with corporations, and for that matter all other business forms, require personal guarantees from the business owners. From a practical standpoint, the affect of shareholder limited liability in the present day business climate only comes into play when there is an uninsured tort claim or where a creditor seeks to make a contractual claim against the corporation, but the creditor failed to secure a personal guarantee with shareholders, to wit, the claimants are limited to the corporate assets.

Since shares are relatively easy to transfer, the corporate form is attractive for those who seek to exit the business through an initial public offering or plan on building the business up then profiting by selling to others. Additionally, except for having to designate directors and officers in the annual statement of information that must be filed with the Secretary of State, shareholders can remain anonymous.

As to tax concerns, the area is complex and again, those starting a business should seek the advice of a seasoned tax professional. The corporation is separately taxed and files Form 1120 with the IRS. Since corporate tax rates are lower than individual tax rates at the higher taxable income levels, it might be advantageous to operate a business as a corporation if the business is generating income at the higher level.

Generally, the corporation’s income is taxed twice, once at the corporate level, that is, the income reported on the corporate tax returns, and a second time when the dividends are distributed to the shareholders, i.e., the dividends that are distributed to shareholders are reported on the shareholder’s personal income tax return and taxed accordingly. Depending on the corporation’s circumstance, this corporation characteristic of “double taxation” can be reduced by paying a salary to a shareholder, who in most instances works for the corporation at least in its “startup” phase. In such a case, the corporation would allocate the same funds that it could use to distribute as a dividend to its shareholder to be paid as a salary to the shareholder. Thus, those same funds would be classified as an expense of the corporation and not taxed at the corporate level. More closely, the corporation would not have to report those same funds distributed to its shareholder/employee as corporate income, reducing the corporate tax liability. Of course the employee would have to report the salary as income on his/her personal returns in the same manner as if the funds were received as a dividend.

            By way of example, If Pizzeria, Inc. makes a net profit of $1,000 in a certain tax year, Pizzeria Inc. would pay a corporate tax on the $1,000. If Pizzeria, Inc. decides to distribute some of its profit as dividend to each of its shareholders, Cary, Charlie and Carly, for example $100, then Cary, Charlie and Carly would each pay an income tax on the $100 dividend, that is, on their personal income tax returns. As such, the $300 of the $1000 in net profit is taxed twice, at the corporate and personal income tax levels. If the facts justify an alternative, Pizzeria, Inc. may instead pay Cary and Charlie, as employees, a $100 Christmas bonus for their hard work in the past year. In the alternative, Pizzeria Inc. may deduct $200 from the $1,000 as an expense that would reduce its corporate tax liability.[14]

In California, corporations must pay an annual franchise tax on income within the state of 8.84% with a minimum of $800.00.[15] Additionally, corporations enjoy a more favorable tax treatment in fringe benefits, for example, group life, health and accident insurance, medical expense reimbursement plans, etc.  Generally, fringe benefits will not be taxable to shareholders and the corporation may deduct the expense from the corporation’s income. Limitations apply to S Corporations, discussed below.

S Corporation

Alternatively a business may be organized as an S Corporation and elect to be taxed under Subchapter S of the Internal Revenue Code.[16] If the corporation makes a timely election, the corporation will be taxed as a partnership. As such, income of the corporation will not be exposed to double-taxation and alternatively would then pass through like partnership income. Additionally, shareholders will retain the protection of limited liability and have the availability of the corporate governance style, e.g., board of directors, corporate officers, etc., and further retain the characteristic of transferability of shares. S Corporations do have limitations in the number of shareholders, kind of shareholder, type of shares, inter alia. Additionally, shareholders who own more than two percent of the outstanding stock do not receive favorable tax treatment for fringe benefits. S Corporation must pay a minimum annual franchise tax of $800.00 but are exempt the first year.

Limited Liability Company

A limited liability company (LLC) is a blend or mixture of the characteristics of a partnership and a corporation. Similar to a corporation, the owners of the LLC, or its “members” have limited liability, specifically members are not personally liable for the LLC’s financial obligations. The LLC is formed by the filing of articles of organization by the Secretary of State. Unlike the corporation, an LLC has only those formalities that it requires in its operating agreement and thus not as rigid as a corporation. The company operating agreement can be formally set forth in writing, oral or in some cases implied.[17] The flexibility can come at a cost however because lawyers are usually retained to draft the operating agreement to include provisions that are less common.

As in a corporation, members of the LLC may be liable under the alter ego theory of liability. Personal liability may be imposed if members fail to follow company formalities that are provided for in the operating agreement or if members personally participated in wrongdoing that injured or caused others to sustain damages, financial and otherwise.

The LLC can be “member-managed” and take on the management characteristics of a partnership with no centralized management and with all members having the ability to contractually bind the LLC to third parties.[18] Unlike a partnership a member’s acts do not open the doors for personal liability of other members. Like a corporation’s shareholders, LLC members enjoy the protection of limited liability. Absent a member’s personal guaranty, it is the LLC assets that creditors may make a claim and not the assets of individual members. If the LLC is member-managed each member owes a fiduciary duty of care and loyalty to the LLC and the other members.

Alternatively, the operating agreement can require that there be a more centralized management, for example require that a board of directors and officers are exclusively authorized to act on behalf of the LLC. If an LLC is managed the way other business forms are managed, legal interpretation of the governance style will be in conformity with the legal precedents relating to the other business form. The usual alternative LLC governance form that is more centralized is a “manager-managed” LLC wherein business operations are managed by one or more managers who may or may not be members.[19] If the LLC is manager-managed, the manager has fiduciary duties to the LLC and its members.[20]

The operating agreement can also establish how profits and losses are allocated, but absent an agreement, profits, losses and distributions are allocated in proportion to the value given to each member’s capital contribution.[21] Usually the manner that profits are allocated corresponds with the weight of members’ votes, but voting interests can be made in any proportion set forth in the operating agreement.

From a tax standpoint, an LLC, like a partnership, is treated as a “conduit” wherein profits and losses are passed through to the LLC members. Like the partnership, members cannot avoid the payment of income taxes by the LLC retaining earnings. The personal income taxes of each member will be based on their proportionate share in the LLC earnings, whether or not the earnings are actually distributed to the member. In California, an LLC must pay an annual franchise tax of at least $800.00.[22] At incomes of the $250,000.00 or more, the LLC must pay a greater franchise tax dependent on certain income levels. Also, the LLC, as is the S Corporation, is limited as to deducting fringe benefits as an LLC expense.

Hawai'i

The State of Hawai'i requires the filing of an annual report with the Business Registration Division of the Department of Commerce and Consumer Affairs (BREG) and depending on the type of transactions of the business, the BREG requires the filing of forms and payment of taxes to comply with Hawai'i's General Excise Tax (GET).  For the most part, a seller's permit is required for retailers or wholesalers of tangible taxable items.

Concluding Thoughts

There are many factors to consider in choosing the appropriate entity in a business startup. It is possible to make changes in the future if the choice does not appear to fit the needs of he owners as the business grows and takes on different challenges. Even so, to make the necessary changes, it is best to lay the proper groundwork, because there are financial penalties that may exist when transferring the assets of the business in one form to that of business in another form. Much credit can be given to those who take on projects and do it all on their own. However, the smart money is placed on those who share the burden and seek help from licensed legal and tax professionals so that the possibility of unanticipated is decreased, naturally increasing the probability of success.

[1] California Business and Professions Code §§17900 and17910

[2] California and Professions Code §17917

[3] California Business and Professions Code §14411

[4]  California Family Code §§910(a), 297.5

[5] C. Hugh Friedman, James Fontenos and Edward C. Rybka California Practice Guide: Corporations §2:86 (2017)

[6] California Corporations Code §16202(a)

[7] California Corporations Code §16301(1)

[8] California Corporations Code §§ 16305, 16306

[9] California Corporations Code §§ 16103(b)(3)-(5),16404

[10] California Corporations Code §16801

[11] California Corporations Code §§ 15903.03(a)

[12] 26 U.S.C. §702-704

[13] 26 U.S.C. §702

[14] A competent and licensed accountant should be consulted as to the tax consequences of distributions and whether wages and salaries may be made to shareholders, directors and officers.

[15] California Revenue and Taxation Code §§23151, 23153

[16] 26 U.S.C. §1361-1379

[17] California Corporations Code §17701.02

[18] California Corporations Code §17704.07

[19] California Corporations Code §17702.01

[20] California Corporations Code §17704.09

[21] California Corporations Code §17704.04

[22] California Revenue and Taxation Code §17941, 23153