Business Formation

Our Business Formation practice consists of advising and representing clients in the areas of business formation and corporate counsel. We serve as corporate counsel and business adviser to many small and medium-sized closely held companies that emerge as start-ups and grow into mature companies.

We also help those business owners plan their exit strategies. This could entail planning to sell the business and retire or pass it on to the next generation. There are many tax and legal issues to consider not only when running a company but also when exiting a company. We are here to help guide you and work with your other planning professionals to ensure you make all the right moves.

During the life of a business it is often necessary to implement other strategies such as share holder agreements or buy-sell agreements. We represent our business clients in these areas as well to make sure they are making the right choices for their business.

What are some of the considerations for choosing a business entity to run your business?

There are several ways to operate a business in most states. In California we have many options. Some have better liability protection than others. Some are restricted to multiple owners. Below we will examine the possibilities for running a small to mid-sized business that is closely held.

There are six main types of business entities that can be formed to operate a business. They are the sole proprietorship, a general partnership, a limited partnership, an S corporation, a C Corporation, and the Limited Liability Company (LLC).

You’re probably wondering which business entity is right for my business. Let’s take a look at the legal and tax implications of each business entity type.

The first entity type is the sole proprietorship. Any sole proprietorship will vest liability with the person that owns the business. This means that if the business owner is sued for something related to the business, they will be sued in their personal name and their assets outside of the business maybe subject to the creditor or the lawsuit. A sole proprietor may engage in any type of lawful business. A sole proprietor business consists of only one owner.

Sole proprietors are often asked to “guarantee” debts for their business which means they will be personally liable. If the business owner dies, the sole proprietorship automatically dissolves. There are also no restrictions on transferring the business to a new party. Lastly, there are minimal organizational requirements associated with a sole proprietorship, but in most jurisdictions, at least a business license is required.

The next entity that we will focus on is the general partnership. General partnerships consist of two or more partners. The general partners are personally liable for any debts that the business incurs. General partnerships may generally engage in any lawful business activity.

Management decisions are made by the general partners. Any general partner may legally obligate the business. If a general partner dies, the partnership dissolves automatically unless otherwise stated in a partnership agreement. In order for a general partner to transfer an ownership interest, the consent of all general partners is usually required under the partnership agreement.

There is minimal organizational paperwork and ongoing legal formality with a general partnership. However, a partnership agreement is strongly recommended to avoid misunderstandings down the road and to lay out the treatment of the partnership interests should a partner die or become disabled.

Next, let’s turn our focus to the limited partnership. The limited partnership has general and limited partners. Only the general partners are liable for business debts. Generally, a limited partnership may engage in any lawful business. In a limited partnership, you must have a minimum of one general partner and one limited partner. The general partner or partners make management decisions. Any general partner may obligate the business.

As in a general partnership, if a partner dies, the partnership automatically dissolves unless otherwise stated in a partnership agreement. Transfers of ownership interest generally require consent by the general partners. Organizational paperwork includes a start up filing and a partnership agreement is strongly recommended.

Now, let’s examine the “S” Corporation. An S Corporation is much like a C corporation except that it has a sub-chapter S election with the IRS. What this means is that the S corporation is a pass-through tax entity to the business owner. The owner would only pay taxes at the individual level. Whereas a C corporation pays taxes both at the corporate entity level and any profits that pass through to the business owner are taxed to them on their personal return as a shareholder.

The shareholders are the owners of the S corporation. If the entity is properly maintained, there’s no personal liability for the shareholders if there is a lawsuit or creditor issue in general. Exceptions to this rule include professional service providers such as doctors, lawyers, dentists, etc. (see Chapter 6). If a professional service provider commits malpractice, that practitioner can still be held liable for the damage caused. Therefore, it is strongly advised that these types of professionals carry adequate amounts of malpractice insurance coverage. However, any business debts arising out of the usual course of business, such as basic business contracts, will provide a veil of protection for the shareholder from personal liability.

There are restrictions on how many shareholders there may be in an S corporation. An S corporation may have up to100 shareholders but of whom must all be US citizens or residents. An S corporation may also consist of just one single shareholder. The Board of Directors makes management decisions in an S Corporation. If there are less than three board members, there must be at least the number of board members equal to the number of shareholders. Directors and officers may legally obligate the corporation.

There’s no effect on the business if the business owner dies or departs from the business.  The corporation may continue on. The transfer of stock may be regulated by the bylaws or restricted in the articles of incorporation. However, transfers should be limited to persons or entities that qualify as S corporation shareholders. There is a start up filing required called the Articles of Incorporation that must be filed with the California Secretary of State. Additional organizational paperwork includes the execution of corporate bylaws, an organizational meeting with minutes, issuance of corporate stock, and a Statement of Information filing.

The next entity type we will examine is the C Corporation. As in an S corporation, shareholders own the business. Generally, if all corporate requirements are met, there will be no personal liability of the shareholders. A C corporation may not be formed for banking or trust business. A one person C corporation is allowed. Management decisions are made by the Board of Directors. If there are less than three board members, there must be at least an equal number of board members to the number of shareholders. The directors and officers in a C corporation may legally obligate the business.

There is also no effect upon the death or departure of a shareholder on the existence of the corporation. Transfers of stock can be limited under securities law or there may be restrictions in the articles of incorporation or bylaws. There is a start up filing required just as in the S Corporation which is called the Articles of Incorporation. You also need Bylaws, an organizational meeting with minutes, issue of corporate stock, and a Statement of Information filing with the Secretary of State.

Lastly, let’s discuss the details of an LLC or otherwise known as a Limited Liability Company.  The owners of a limited liability company are called members. There is no personal liability of the members for debts or other liabilities incurred by the Limited Liability Company (unless the member executes a personal guarantee. There are restrictions on the types of businesses that can operate as an LLC. An LLC cannot be formed for banking or trust business and may not be used by professionals that are licensed such as lawyers accountants and architects unless they form a special type of professional limited liability company. California allows one member LLCs. The members of an LLC make the management decisions. However, if a manager is elected, then the manager makes the management decisions of the LLC. Ordinarily, any member of the LLC may obligate the business if there is no manager. If the business is manager-managed, then the manager may obligate the business.

The length of term that the LLC can continue in existence is usually listed in the LLC operating agreement. Most agreements are drafted to state that the LLC can continue even after a member leaves or dies. Most LLC operating agreements require that the members must first consent to the admittance of new members to the LLC.

A start up filing with the Secretary of State is required. This is called the articles of organization. An operating agreement for the LLC should also be drafted but annual meeting minutes are not normally required (unless the LLC is set up that way). There may however be a compelling reason to memorialize important business decisions in meeting minutes of an LLC. As with an S corporation or a C corporation, a statement of information needs to be filed annually with the Secretary of State. Membership share certificates should also be issued to the members of the LLC to evidence ownership.

When there is more than one owner (a general partnership, a limited partnership, an S corporation, a C corporation, or an LLC) buy-sell agreement language should be in the governing operating agreement or there should be a stand-alone Buy-Sell agreement for the owners. For more information on Buy-Sell agreements, see Chapter 5 of this book.

Now let’s turn to the tax characteristics of each business entity type. A sole proprietorship is taxed at the individual tax rate of the sole proprietor. A general partnership is taxed at the individual tax rate of the general partners unless the partners file form 8832 electing corporate tax treatment. The same is true for the partners of a limited partnership.  For the C Corporation, there is a split up and taxation at the corporate tax level and at the individual tax rate of the shareholder.

There is also an $800 minimum state franchise tax board fee that is due on an annual basis to the state Franchise Tax Board. In an S corporation the shareholder is taxed at their individual tax rate. This is called pass-through entity treatment. An $800 minimum state franchise tax board fee is also due annually for the S corporation. The LLC has pass-through entity taxation to the members unless the LLC files an IRS form 8832 and elects corporate tax treatment. The LLC must also pay an $800 minimum state franchise tax board fee plus additional fees if the gross income of the LLC is above $250,000. All of these entities have automatic tax status treatment except for the S corporation. For an S Corporation to be treated as a pass-through entity, the corporation must file an S election with the IRS.