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Which Type of California Business Entity is Best for you?

The Following Questions Are Designed To Help You Decide Whether a Subchapter S Corporation or a Limited Liability Company (LLC) or Another Entity - Such as a Sole Proprietorship, C Corporation or Limited Partnership - is Best For Your Business.

TABLE OF CONTENTS

Sole Proprietorships
Corporations
Limited Liability Company (LLCs)
The Differences Between Corporations and Limited Liability Companies
Comparison of "Pass-through" Entities

SOLE PROPRIETORSHIPS

If you are a sole owner (or you and your spouse are the sole owners), sole proprietorship may be the way to go: the tax advantages are usually better than with a corporation or LLC, and you avoid the cost and administrative time of establishing and maintaining a separate entity. (You also have to pay the State an $800 annual minimum tax for the privilege of having an LLC or corporation.) Although with a sole proprietorship your personal assets are not protected from litigation, often sufficient protection can be provided through insurance. Still, there are other considerations.

Will There Be Other Owners or Investors Other Than You and Your Spouse?

If so, you almost certainly want to form an LLC or corporation. Otherwise, you have a General Partnership and you are personally liable for any contracts your partner enters or acts your partner takes with respect to the business. In addition, a Subchapter S corporation may be better than a partnership in terms of the self-employment tax that must be paid.

Will forming a business entity give you more credibility with potential (or current) customers, vendors or business partners? If so, forming a business entity may be worthwhile.

Is your business in a field where high-stakes litigation is possible? The more likely this prospect is, the more reason to form a business entity - if only for peace of mind.

CORPORATIONS

Do You Expect the Company to Provide Extensive Benefits (Health Insurance, Retirement Benefits, Etc.)?

If so, a "C" corporation should be considered. If you can set salaries and bonuses so that there is no profit, a "C" corporation may be best, since certain fringe benefits are tax deductible but are not counted as income for employees. Employer payments for health insurance premiums and other medical expenses is deducted as a business expense, but isn`t included in employees` gross income. Employer payments for the following are treated the same way: (a) employees` life insurance benefits; (b) accident and disability benefits; (c) death benefits; and (d) supplementary unemployment benefits; (e) employee parking expenses and employer-provided transit passes (up to certain limits); (f) child care; (g) meals and travel lodging.

Do You Need to Carry Large Amounts of Revenue From One Year to the Next?

Although salaries and bonuses can often be set to minimize profits, if a C Corporation has profits there is double taxation. (Passive investors will often insist that there be profits.) More specifically, the "C" corporation pays taxes on its profits and the owners pay taxes on their salaries and any dividends. With Subchapter S Corporations and LLC`s, the profits and losses flow through to the owners in proportion to their percentages of ownership.

Do You Want To Offer A Stock Option Plan To Employees?

Only a corporation can set up an Incentive Stock Option Plan ("ISOP") where the employee does NOT pay taxes at the time the option is exercised but only when the employee sells the stock. Still, even a corporation can only offer an ISOP to employees and not to outsiders. Also, an LLC (as well as a corporation) can offer options/warrants, although the employee is taxed at the time he/she exercises the option on the difference ("spread") between the amount the employee paid for the stock (the exercise price) and the value of the stock at that time. An LLC (as well as a corporation) can also use a profit-sharing ("Phantom Stock") plan. Still, if you want to offer an ISOP, you need a corporation.

Will the Entity Eventually Have More Than 75 Shareholders?

A Subchapter S corporation cannot have more than 75 owners; a regular corporation and LLC can.

Will the Entity Be Receiving More Than 25% Of Its Income From Passive Investments?

If so, the IRS can terminate a corporation`s S status if its income from passive investments is more than 25% of its total income for more than three years in a row. This makes a Subchapter S corporation unattractive for real-estate businesses. (Passive income is income from dividends, interest, royalties, rent payments, annuities, etc. - as opposed to income directly generated by your labor.)

My Partner is a Permanent Resident--Not Yet a U.S. Citizen. Can My Business Be a S-Corporation?

No. Non-resident aliens may not be owners of a Subchapter S corporation (although they may be beneficiaries of a small business trust that CAN be an owner of a Subchapter S). For this purpose, the IRS definition is used: basically, a non-resident alien is any non-citizen or legal permanent resident who has not been physically present in the United States on at least 31 days during the current year, and 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting: All the days he/she was present in the current year, and 1/3 of the days he/she was present in the first year before the current year, and 1/6 of the days he/she was present in the second year before the current year. (26 U.S.C. Section 7701(b)(3)).

Are You Planning to Allow Anyone to Purchase Shares By Providing Future Services or Giving a Promissory Note?

With a corporation, an agreement to provide future services cannot be used to purchase stock. If a promissory note is used to purchase stock, the note must be adequately secured by collateral other than the stock itself, unless it is given pursuant to a stock purchase plan or a stock option plan. (California Corp. Code Sections 409(a).

An LLC has no such restrictions. (California Corp. Code Section 17200(a).

Can My S Corporation Have More Than One Class of Stock?

No. A Subchapter S Corporation can only have one class of stock. Differences in voting rights are not considered different classes for purposes of S status. On the other hand, debt that is convertible to stock and stock with different distribution rights ARE considered different classes of stock. Straight debt is not considered a second class of stock so long as the borrower cannot alter the due date and the interest payments are not contingent on profits or on the borrower`s discretion. (Deferred compensation is not considered a different class of stock, though.)

Does My Corporation Have to Pay $800 The First Year I Establish It?

No. Corporations do not have to pay the California $800 minimum franchise tax during their first year. RTC §23153(f)(1). LLC`s do. (A Subchapter S still has to pay 1.5% of any profits it has during the first year.)

If I Need a License to Work, Can My Business Be a LLC?

No. If you are licensed under the California Business & Professions Code or under the California Chiropractic Act or the California Osteopathic Act, you cannot form a LLC to practice those licensed services. (Corp. Code Section 17375.) This vast group includes doctors, lawyers, accountants, licensed contractors, cosmetologists and they would form a Corporation or a Limited Liability Partnership.

Will the Entity Initially Have Investors That Are Not Individuals, Like Other Corporations or LLC`s?

If so, how far in the future? (Subchapter S corporations can only have individuals and certain trusts as owners.) If you will be having entities as investors on startup or soon after, then an LLC is the only option for preserving profit/loss pass-throughs.

In contrast to an LLC, if you are a shareholder of a Subchapter S corporation you do not have to pay the self-employment tax on profits that pass through to you as a shareholder. Of course, if you`re an employee of the Subchapter S corporation, you must pay the withholding tax on money you receive as compensation for services. (You MUST take a "reasonable" amount of salary - within the salary ranges for that position in that industry in that geographic location - as compensation if you are working for the corporation.) One negative side to this is that the amount that can be contributed to a retirement plan is based only on the money you receive as salary and not on the money you receive as profit pass-through.

LIMITED LIABILTY COMPANY (LLCs)

Can LLC Members Have Different Percentages, Ownership and Voting Power?

With a Subchapter S Corporation, each owner has the same percentage of ownership, voting power, and profits and losses. With a LLC, for example, a member can have 25% of the ownership (meaning 25% of the proceeds if the LLC is sold), 10% of the voting power and 5% of the profits and losses. (It is possible to control voting in a corporation with a voting trust, though it can be complicated.)

Will the Entity Have Large Revenues Compared with Profits?

LLC`s pay an extra California tax based on revenues; Subchapter S Corporations pay an extra California tax based on profits.

Will the LLC Be Receiving Substantial Profit Pass-Throughs?

With an LLC, each owner who a) is empowered to sign contracts on behalf of an LLC (which includes managing members and members of LLC`s that are member-managed) or b) spends more than 500 hours in a year on the LLC`s business probably has to pay the self-employment tax on ALL money that he/she receives that is in addition to his/her compensation as an employee (where withholding is already being done). The self-employment tax is equivalent to withholding for employees for Social Security and MediCare, but includes both the employer and employee portions; currently this is currently 15.3%.

Can I Convert My LLC to a Corporation?

Yes. Conversion from an LLC to a corporation is not a problem from a tax perspective. You still have the fees to handle the conversion, of course. Converting from a corporation to an LLC will be a taxable event IF the value of the corporation has appreciated since its formation.

Is the Entity Being Formed for the Purpose of Investing in Real Estate?

If there is more than one owner, counting a husband and wife as one owner, taking title as tenants in common may be appropriate. (Tenancy in common is not a legal entity, but a way for multiple people to own real estate.) Tenancy in common (TIC) allows owners to be able to buy and sell their individual interests freely as part of 1031 exchanges. TIC without more is risky, since the TIC owners are deemed to be part of a general partnership. As a result, each owner`s assets are fully at risk for whatever liability that the other TIC owners create or that arises from the real estate. For individuals, the safest approach is to form a corporation or LLC and then have that entity take TIC ownership.

The Differences Between Corporations and Limited Liability Companies

in Structure and Management

1. Corporations

a. The owners are shareholders and receive stock certificates. The shareholders elect the board of directors annually.

b. The board of directors sets the general direction of the corporation and votes on major decisions, but does not engage in day-to-day management. It also elects/fires the officers on an as-needed basis.

In California, if a corporation has one shareholder, there only needs to be one director, but there can be more. If a corporation has two shareholders, there needs to be at least two directors, but again, there can be more. If a corporation has three or more shareholders, there needs to be at least three directors, but there can be more. (California Corporations Code Section 212.)

c. The officers run the business on a day-to-day basis.

In California, three officers are required: President, corporate Secretary and CFO/Treasurer. Other officer positions - CEO, Vice President, etc. - are optional. One person can fill all three (or two of the three) required positions, but banks often require that different individuals fill the President and Secretary positions unless there is only a single shareholder.

d. California corporations must hold one shareholders meeting annually and it is strongly recommended that they hold at least one board of directors meeting annually (actually, the resolutions simply can be signed by all directors) and whenever a major decision needs to be made.

e. With a corporation, each owner has the same percentage of ownership, voting power and, if the corporation is a Subchapter S, profits and losses.

2. Limited Liability Companies (LLC`s)

a. LLC`s generally do not have shareholders, directors or officers.

b. The owners of an LLC are members and frequently have membership "units".

c. LLC`s can have one of two management structures: member-managed - where each member takes an active role in running the business and can sign contracts (like a general partnership) -- and manager-managed - where one or more managers operate the business and sign contracts (like a limited partnership). In any case, no meetings of the managers or members are required to be held.

d. Often the operating agreement requires that extremely major decisions (such as sale or dissolution of the LLC) be made by a majority or super-majority (more than 50%) of the ownership interests.

e. With an LLC, an owner can have different percentages of ownership (meaning the percentage of proceeds if the LLC is sold), voting power and profits and losses. For example, an LLC owner can have 25% of the ownership (meaning 25% of the proceeds if the LLC is sold), 10% of the voting power and 5% of the profits and losses.

Comparison of "Pass-through" Entities (All Pay $800/year Minimum Tax in California)
	Subchapter S Corporation	Limited Liability Company	Limited Partnership
Can be formed to practice a licensed profession?	Yes	No	No
Non-resident aliens can be owners?	No	Yes	Yes
Entities allowed as owners (as well as individuals)?	No	Yes	Yes
Paper losses deductible beyond investment amount?	No	Yes	No
Can more than 25% of income be from passive investments?	No	Yes	Yes
Different types of ownership allowed?	No: only one class of stock allowed (although voting rights can be different)	Yes	Yes, but limited partners can have no say in management.
Stock option plans allowed?	Yes, all allowed, including ISOP	Only NSOP and Phantom Stock allowed	Only NSOP and Phantom Stock allowed
Additional taxes for California entities	1.5% of profits	~0.25% of revenues	none
Must pay $800 California minimum tax during first year?	No, but still must pay 1.5% of profits	Yes	Yes
Self-employment tax	Not paid on any profit pass-throughs, although a reasonable salary must be paid on work for the corporation.	Paid on all profit pass-throughs received, at least if owner has contract-signing authority (is a managing member or LLC is member-managed); also probably paid if owner without contract authority spends more than 500 hours in a year on the LLC`s business.	For limited partners, not paid on profit pass-throughs. General partners, if individuals, must pay self-employment tax on the profit pass-throughs.

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