Should I Form a Corporation, LLC, or Partnership?

Posted 2023-02-03

Understanding the Primary Business Entity Types Available in California

If you are thinking about setting up a business and wondering whether you should form a corporation, LLC, partnership, or perhaps something else, then you’ve come to the right blog post.

Choosing the right type of business entity is a very important decision. The decision can affect:

how the business will raise money
the risk of personal liability of the owners for the debts of the business
taxes
whether the business will ever be able to go public
the ease/difficulty in passing down the business to the heirs of the owners after death

A mistake in selecting the right business entity structure can be very costly and handcuff the business until it is forced to restructure later on. It can also cost the business owners a lot of money. Sometimes, the mistake will make itself obvious rather quickly, and other times it may not manifest until such a time as the business attempts to do something it is not allowed to do by virtue of its structure.

In California, there are essentially five primary types of business structures:

Sole Proprietorship
General Partnership
Limited Partnership (LP)
Corporation (Corp)
Limited Liability Company (LLC)

There are various subcategories within some of these types of entities (e.g., the professional corporation, not-for-profit corporation, benefit corporation, cooperative, etc.), as well as some niche entities that are only usable by certain professional enterprises (e.g., In California, the limited liability partnership can only be used by lawyers, architects, and accountants for their respective professional practices).

This article gives a brief overview of the different types of primary business entities available in California, including some of the pro’s and con’s. It is by no means exhaustive, and is not intended as legal advice. If you need legal assistance, you should contact a business law attorney.

Sole Proprietorships:

Basics: The simplest business “structure” is the sole proprietorship. It essentially is a “structure” without any structure. In other words, it has no distinct legal structure from that of the individual. This makes a sole proprietorship the easiest to “form”. The owner of a sole proprietorship is known as the “sole proprietor” or “proprietor” and owns and operates the business in his/her individual capacity. Sometimes the sole proprietor might operate the business under a “doing business as” (“D.B.A.”) name.

A D.B.A. registration is not required, but it may be necessary in order for the sole proprietorship if it intends to collect payments in a name other than the name of the owner.

Personal Liability Risk: The owner of a sole proprietorship has unlimited liability for the business’ debts and liabilities, meaning that if the business cannot pay its liabilities, the owner will remain personally liable. It also means that if a customer sues the business, the customer is essentially suing the individual owner, and any damages will be recoverable from the sole owner (i.e., from the owner’s home).

Taxation: Sole proprietorships are taxed on the owner’s personal tax return via Schedule C.

Continuity/Legacy: When a sole proprietor dies, the business almost always dies too. And usually within a short amount of time. It is one of the worst kinds of structures if the owner’s intention is to maintain the benefits of the business even after the owner’s death.

Miscellaneous. If more than one person owns the business, then the business cannot be a sole proprietorship. The business must choose one of the other types of entity forms if there is more than one owner.

General Partnership

Basics: A general partnership is a business based upon a contractual obligation between two or more people. With a partnership agreement, the partners essentially join together to share ownership, management, and profits. There is no limit to the number of partners in a general partnership.

Personal Liability Risk: Akin to the sole proprietorship, the partners in a general partnership have unlimited risk of liability for the debts, liabilities, and obligations of the business. But the risk is even worse for partnerships because each general partner is jointly and severally liable for all of the obligations of the partnership. This includes all other partners’ mistakes and misdeeds (except for the unpaid taxes of a partner).

Taxation: Taxes flow through to the partners. The partnership itself does not pay the tax, but rather it apportions each partner’s tax obligation via a Schedule K notice provided to the partners, upon which each partner is obligated to pay their stated share of taxes.

Continuity/Legacy: A partnership agreement can place limitations and/or requirements upon the distribution of a partnership interest to a deceased partner’s heirs. If ignored, however, a partner could end up with unwelcome and unqualified new business partners, and could also be obliged to carry a business on while the deceased partner’s interest is stuck in a legal fight and/or a long, drawn-out probate proceeding.

Limited Partnership

Basics: A limited partnership is a special kind of partnership. Similar to a general partnership, a limited partnership flows from an agreement between the partners. A limited partnership, however, has two different classes of partners. Specifically, a limited partnership must have at least one limited partner and one general partner.

Personal Liability Risk: Unlike a general partner, a limited partner is not fully liable for the debts and obligations of the business. A limited partner’s liability is normally limited to the amount of control or participation the limited partner has within the partnership. The general partner will have unlimited liability. If there are multiple general partners, they will be jointly and severally liable for all obligations of the partnership.

Corporation

In the spirit of William Shakespeare: ‘To form a corporation…or not form a corporation? That is the question.’

Basics: A corporation is a distinct legal entity. It arises from the laws and express charter of the respective state of incorporation. Upon creation and for so long as it is properly maintained and renewed, it has its own separate and distinct legal identity. Assuming it follows the proper legal formalities, it can enter into contracts, own property, and operate in its own name for the benefit of its owners. The owners of a corporation are called shareholders.

In general, some of the advantages of forming a corporation include:

Limited liability protection for shareholders against claims arising from debts or obligations incurred by the corporation (i.e., if a corporation borrows money to buy equipment or real estate for the company’s business purposes, the shareholders will generally not be personally responsible for these debts.)

The ability to raise funds to operate the business through selling shares (referred to as “issuing stock”). These funds may be used by the company for any lawful purpose; however, this practice is subject to state and federal securities laws.

Can create different classes of shareholders so that there may be varying distribution and voting rights depending on the class of shareholders.

When structured properly at the outset, corporations can be designed in many different ways depending on the goals of the founders. For example, corporations can be structured to protect the rights of the founders or minority interests (e.g., shareholders owning less than 50% of the stock), protect the company from hostile acquisitions, promote continuity of ownership, incentivize growth, minimize infighting amongst the management team, etc.

Personal Liability Risk: As eluded to above, shareholders are not liable for the debts and obligations of the corporation. Corporations must abide by their own corporate bylaws, as well as the corporate law within their home state. They must adhere to certain formalities so as to preserve the corporate protections. Otherwise, they run the risk of exposing their shareholders to personal liability for corporate liabilities.

Taxation: The taxation of a corporation and/or its shareholders depends on the way the corporation elects to be taxed.

“C” Corporations: By default, corporations start as “C” corps. As such, the income earned by a corporation is taxed twice. First, at the corporate level. Then again at the shareholder level (assuming there are dividends paid to shareholders). This is referred to as the “double taxation” of “C” corporations.

“S” Corporations: An eligible corporation can timely file IRS Form 2553. If it does, it can elect to be taxed as an “S” corporation. After that, and for so long as it remains eligible, taxes will only accrue at the shareholder level. In many cases (but not all!), it may be advantageous for a company be taxed as an “S” corporation. However, not every corporation is eligible to be an “S” corporation. An “S” corporation can also lose its “S” corporation status if it violates the eligibility requirements.

Continuity/Legacy: If the stock is not restricted in such a manner, shares can generally be passed down to the heirs. Generally speaking, “C” corporation stock is inherently easier to pass along to heirs than “S” corporation stock. “S” corporation stock may only be owned by certain kinds of eligible entities and persons. That said, with proper planning, “S” corporation shares can also be devised to the heirs. This is an area with the potential for costly pitfalls though. Speak with a qualified business and estate planning attorney before devising privately held stock (i.e., not publicly traded stock).

Limited Liability Company (LLC)

They tend to be popular, but does that mean you should form an LLC?

Basics: The Limited Liability Company (LLC) is the most popular business entity type in California. An LLC has some of the best features of a corporation, but with more flexibility. That said, LLC’s can face a harder time when attempting to raise money from investors, as compared to a corporation.

Personal Liability Risk: An LLC provides limited liability protection for its members, while also having less formality requirements.

Taxation: LLC’s are flexible. They choose to be be taxed as a partnership, as a “C” corporation, or as an “S” corporation. If solely owned or owned exclusively by a husband and wife, the LLC can be taxed as a “disregarded entity.” This is essentially the same as a sole proprietorship’s taxation.

Continuity/Legacy: If allowed by the operating agreement, an LLC member may pass down its interest to its heirs. A member of an LLC taxed as an “S” corporation, however, must plan carefully. Otherwise, they may inadvertently destroy the company’s “S” election. This is an area with the potential for costly pitfalls. LLC members should speak with an experienced business and estate planning attorney before devising membership interests to their heirs.

Misc.: An LLC can by managed by its owners (e.g., the LLC’s “members”) according to their respective membership interest. Alternatively, it can be managed by “managers” (which may include non-members) in accordance with a predetermined management structure. The predetermined structure does not necessarily need to be tethered to the proportional ownership of the members.

Final Thoughts

Choosing the right business entity type is a very important decision. Each type of business has its own benefits and drawbacks. It’s advisable to speak with an experienced professional before making that decision.

Please feel free to call Koza Law Group. Call us at (760) 487-8330.

corporations, LLCs, partnerships, sole proprietorships