Transforming a business from an abstract idea to a tangible entity is a big part of what makes entrepreneurship so intimidating. As part of your initial business planning, entrepreneurs must consider how to manage their business and weigh the potential risks, benefits and costs of different structuring options available in California.
There are four common types of structures to choose from and selecting the right form of entity early is important. Here are some questions to keep in mind when evaluating your options: To what degree do you want your business to subject you to potential personal liability, beyond the business assets and revenue? How do you want to manage your business, and to what degree do you want to define the roles of various partners, members or owners? How do you want to manage your business, financially, and try to take advantage of tax benefits, write-offs and/or implement tax planning?
Consulting with a lawyer and an accountant can help determine the answers to these questions, but a basic understanding of the four main types of structures will save time (and probably money).
1. Sole proprietorship
The simplest, most common structure is a sole proprietorship, where the business and the owner are one, and “doing business as” a fictitious name (more commonly referred to as DBA). Beyond obtaining a business license, filing the DBA, and negotiating or revising standard operational agreements, sole proprietorships require little legal capital and can be formed quickly. Taxable income and expenses are reported on the owner’s personal tax return, and owners are individually liable. Sole proprietorships are quick, easy and cheap to set up — generally more so than other structures. However, you’ll assume all liability for your business and it’s important to consider your comfort level with that much exposure.
The second most common entity is a partnership, which can vary in form but can be created any time two or more individuals agree to a share in profits and losses of a business. Partnerships can be formed verbally or in writing. California has laws that assist in governance of a partnership, but without a good written agreement that defines each partner’s rights, duties and obligations, one or both partners could be put at professional and financial risk and the effects can take years to recover from.
There are two kinds of partnerships: a general partnership and a limited partnership. A general partnership is where each partner owns an agreed-upon percentage interest of the partnership and management duties are usually divided; the partners are legally responsible for the partnership’s debts and legal obligations.
In limited partnerships, you own an interest in the partnership, but your main risk is whatever cash, capital or liabilities you assume and contribute to the partnership. If you’re a limited liability partner, the law requires management and control of the partnership to rest with others — although you can still require a vote or approval of material changes, such as the sale of the partnership or the introduction of other partners. Managing partners owe duties to the partners, so if you are going to form a partnership (whether general or limited) it’s important to consult with an attorney to outline those duties. A good partnership agreement can assist in situations where disagreements exist or when a dissolution between the partners is necessary.
3. Limited liability companies
LLCs have become more prevalent over the last few decades and provide an excellent vehicle to manage and conduct business. At the ownership and management level, an LLC is basically a hybrid between a corporation and a partnership. LLCs can be formed relatively quickly; members acquire and own a percentage of the LLC, and there is flow-through taxation, which means that while there is a tax return prepared for the business, taxable income and tax liability falls on the owner or owners, instead of the business. The rights and obligations of the members, as well as the managers of LLCs, are usually defined in the “operating agreement.” Like a corporation, the owners have limited liability, yet there is less formality. Unlike a partnership, LLCs can be owned and managed by one member.
Finally, a corporation is a legal entity owned by shareholders. Corporations are managed by their corporate officers, who follow the corporation’s bylaws, articles or corporate agreements. The officers are appointed and serve at the will of the corporation’s board of directors. California provides for limited liability and protections of a corporation’s shareholders, assuming protocols, formalities and other corporate requirements are properly observed.
The two most, common types of corporations are “C” and “S” corporations. C corporations are taxed at the corporate level, and if dividends are distributed to the shareholders, then also at the shareholder level. This is sometimes referred to as double corporate taxation, but also allows the corporation to shoulder the tax exposure. S corporations, like a partnership or LLC, have profits and losses that are reported and flow through to the shareholders based on their ownership.
Determining what entity or structure is best for your business involves a number of considerations, including the balance between what is practical, functional, cost effective, and protects you and your business. It’s best to consult with an attorney to help identify how to establish the right entity and structure up front, so you can minimize your risk long-term.