Entity Formation Spectrum
Entity selection is a critical decision for your business and is an important way you can secure your legacy.
I lay out the options here on a spectrum to illustrate how back in the day there only the two ends of the spectrum for choices – your business would be a sole proprietorship if you were the only owner, or a general partnership if you had a co-owner. On this end of the spectrum there is pass through taxation – meaning only the owner pays the tax on the profit of the business, the entity does not also pay tax. The downside is that there is no liability protection – meaning any lawsuits against the business would also be against the owner(s) and their personal assets.
If you wanted liability protection you had to go to the far other end of the spectrum and form a corporation – now referred to as a “C-Corporation.” This would provide you with liability protection in order to isolate the business assets away from your personal assets.
In order to get this liability protection, you were making a few trade-offs – namely you lose the pass through taxation. In a C-corporation you have what is referred to as double tax – meaning the business pays tax on its profit based on the corporate tax rates, then it distributes money to the owners who again pay tax on those same dollars.
In addition to the double tax downside, a corporation also requires annual formalities to maintain its existence – such as annual meetings and minutes, all of which cost time and money.
Enter into this polarized dynamic the LLC – Limited Liability Company. This was designed to be the best of both worlds – the hybrid between the Sole Proprietorship and the Corporation. It had the benefit of liability protection along with pass through taxation – and to make it even sweeter there are no requirements for annual formalities! Sounds too good to be true – well it may be…
Other states had the LLC before California. This entity type is a state law construct – meaning the IRS does not recognize this as a stand-alone entity type for tax purposes. After much lobbying, the state of California authorized LLC’s, but they charge an additional fee – Of course! This is California 😊
This extra fee for having a California LLC is a big downside to selecting this entity. Each entity type in California pays a minimum of $800 annual tax, but the LLC will pay additional fees based on its total gross revenue – even if it doesn’t make any profit!
California LLC Gross Receipts Fees are based on the businesses Gross Revenue:
$250,000+ = $900
$500,000+ = $2,500
$1,000,000+ = $6,000
$5,000,000+ = $11,790
There is also now the option of selecting an S-Corporation. If all the shareholders qualify (there are certain restrictions on US citizenship, etc.) and there will be less than 100 shareholders you can choose to be an S-Corp – the small business corporation. This entity type gives you the benefit of pass through taxation like an LLC and Sole Proprietorship without the gross receipts fee.
One potential downside to an S-Corporation is that you are required to have annual formalities – annual meetings and minutes. These required meetings can be a good opportunity to work on the business instead of just in the business, but they do take time and money and if you fail to maintain these annual formalities it may give rise to cracks in your liability protection allowing a creditor to pierce the corporate veil and come after the shareholder’s personal assets!
If you are going to have an even smaller business – meaning less than 35 owners (which in my world is still a pretty big business!) you should consider the Closely-Held S-Corporation option. On the spectrum you will see that I place this right next to the LLC because it is very similar to that – apart from the ownership restrictions for an S-corporation and the 35 owner limit. The benefit to what is referred to in California Corporations Code Section 158 as a “Close Corporation” is that:
The failure of a close corporation to observe corporate formalities relating to meetings of directors or shareholders in connection with the management of its affairs, pursuant to an agreement authorized by subdivision (b), shall not be considered a factor tending to establish that the shareholders have personal liability for corporate obligations. CA Corporations Code Section 300(e).
In English, that means a Close Corporation does not NEED annual minutes and that does not cause cracks in the liability protection provided by their corporation. There are plenty of other things owners can do that will cause their liability protection to be diminished or lost – namely comingling funds – but the lack of annual minutes is not one of those things.
I still highly recommend annual meetings and if you have multiple owners then the legal requirement for them may be the motivation you need to conduct such meetings. Either way, there is no law prohibiting you from having annual meetings with your business lawyer and accountant, just that with a close corporation you will not need to document those meetings with formal minutes!
There are many more entity types but as you can see there are a lot of deliberations that go into making the decision – why not start out on the right foundation by running your business entity formation by an experienced business attorney, like me! I am always happy to talk shop and look forward to working with you.
Jay Pink,
Attorney
