With the end of the year rapidly approaching many people will be looking to start a new venture. The desire to create a new business or venture generally occurs around the end of the third quarter or the beginning of the fourth quarter of each year. It's the end of the year planning and rush.
Usually, the questions we get is: "Should I form a C-Corp, S-Corp, or an LLC?" Always, the answer is: "It depends on what you want to do." Also, we should note, that one question contains about six different questions that involve tax issues.
Let's discuss the entity issues first. Ultimately, when forming a business entity, the paramount issue is limited liability protection, meaning that the business is responsible for the debts, not you personally. When you form an entity at the California Secretary of State, generally, you choose between three separate forms of businesses that provide limited liability protection: (1) Corporations, (2) Limited Liability Companies (LLCs), and (3) Limited Liability Partnerships (LLPs) (rarely do people ask about limited liability partnerships).
As a general rule of thumb, I suggest that people who want to operate a typical for-profit business should elect to form a corporation. Businesses are more conducive to the corporate structure with shareholders, a board of directors, and officers. Having the corporate structure gives the business the ability to grow into that structure and accommodate the growing needs of the business.
Understandably, many businesses start small, with only one or two shareholders. In those situations, the shareholder/owners do not want to be bothered with meetings and rules. In that case, the corporation can be formed as a California Close Corporation. There are two main advantages of being a close corporation. The first is that the corporation may operate more like a partnership based on a vote of the shares, rather than the typical one person, one vote system that comes with a board of directors. And the second is that potential claimants cannot pierce the corporate veil because the business owner failed to keep minutes.
However, as the business grows and adds shareholders, we advise corporations to opt out of the Close Corporation status because any shareholder may seek to dissolve the business.
The second rule of thumb that we follow is that real property is held in an LLC. LLC's are great for holding passive income assets. Real property does not require the day to day involvement that most typical businesses do. The LLC provides the vehicle for simply holding title. We hesitate to recommend LLCs for businesses because California imposes a gross receipts tax which could be substantial depending on the type of business that you own. Furthermore, employee/members of an LLC do not receive a salary, so it makes it difficult to balance owner income and employee income when not all of the members are participating in the day to day business.
The third rule of thumb is that professionals should organize their business in the form of an LLP. There are two main reasons that professionals should be in a partnership. First, professionals often want to be paid what they earned for the business. The LLP provides a very easy means to do so as distributions do not need to be paid based on the ownership percentage in the business. The LLP can make special allocations. Second, professionals (especially in the legal and accounting industries) often change who they want to associate with. The form of an LLP allows this to happen on a much easier basis.
Obviously, these are simple rules of thumb, any situation may be different based on the circumstances of your issue. But when thinking about an entity, think business in a corporation, real property or passive income in an LLC, and professional business in an LLP.
Now, with respect to the tax aspects, please keep in mind that for any entity, you can choose how you want the entity taxed. As a corporation, you can choose Sub-Chapter C status or Sub-Chapter S status. If you want to be a C Corporation, you do not need to do anything, your corporation will automatically be deemed a C Corporation. With respect to being an S Corporation, you will need to file an election within 75 days of the formation of the corporation.
A C Corporation is a typical corporation with double taxation. Some business owners seek C Corporation status because they want to generate funds within the corporation. An S Corporation is a flow-through entity where funds are taxed once but at the shareholder level. Ultimately, you should speak with your CPA about which entity makes the most sense for you.
Partnerships are like S Corporations and taxed only once, at the partner level. However, partnership taxation allows for special allocations so that you can move the taxable events among the partners as needed. S Corporations do not have the benefit of special allocations. It is simply a pro rata allocation.
LLCs have the benefit of choosing how they want to be taxed. Accordingly, LLCs may be taxed as a C Corporation, S Corporation, Partnership, or Sole Proprietorship (assuming it is a single member LLC).
As you can see, determining which type of entity you want to be is no easy decision. There are multiple things that need to be thought out. Moreover, you should consult, both your attorney and your CPA.