A Short Guide for Selecting A Business Entity
Choosing the right entity under California law is a critical decision for any business-owner. Your choice affects liability protection, tax treatment, and long term flexibility. This guide compares the most common California business forms: Sole Proprietorship, General Partnership, Limited Partnership (LP), Limited Liability Company (LLC), and Corporation.
1. Sole Proprietorship
The sole proprietorship is the simplest kind of business organization in that it is an unincorporated business owned and operated by one individual. There is no legal separation between the owner and the business. Because the sole proprietorship is not a legal entity, there are no formal governance requirements to be followed.
- Filings: No filings are required to be made with the California Secretary of State. However, sole proprietors often operate under a “doing business as” or “DBA,” which does require a filing with the appropriate county.
- Liability: A major downside to the sole proprietorship is that the sole proprietor is personally liable for claims made against the business (e.g., tenant claims, breach of contract claims, products liability, etc.). This means that a sole proprietor’s assets (both business and personal) are vulnerable to such claims.
- Tax: Income is reported on the sole proprietor’s individual tax return.
2. General Partnership
A general partnership is an association of two or more persons to carry on as co-owners a business for profit. Generally, an act of a partner that falls within the scope of the partnership business binds the partnership. While flexible, this structure comes with risk from a liability standpoint.
- Filings: A partnership is formed upon the parties’ carrying on of a business for profit together (whether or not the parties intend to form a partnership). As such, no filing needs to be made with the Secretary of State to form the entity.
- Liability: Partners in a general partnership (like sole proprietors) are personally liable, jointly and severally, for partnership debts, obligations, and liabilities. This means that (i) a creditor can sue one partner alone for all obligations of the partnership owed to such creditor and (ii) such partner’s assets (including personal) are exposed.
- Tax: Income of the general partnership is passed through to the partners, which is reported on the partners’ tax returns.
3. Limited Partnership (LP)
A limited partnership is a partnership comprised of at least one general partner (with unlimited liability for the obligations of the partnership) and one or more limited partners (whose liability is generally capped at their investment). This structure is useful for real estate syndications or agricultural operations where passive investors contribute capital but don’t want control.
- Filings: A Certificate of Limited Partnership must be filed with the Secretary of State to form the entity.
- Liability: General partners (“GPs”) manage the operations of the partnership and carry full liability for liabilities of the limited partnership. Limited partners (“LPs”) provide the capital and are not personally liable for the liabilities of the limited partnership.
- Tax: Income of the limited partnership is passed through to the partners, which is reported on the partners’ tax returns.
4. Limited Liability Company (LLC)
A limited liability company (LLC) is a hybrid structure offering limited liability (like a corporation) and pass-through taxation (like a partnership or sole proprietorship). LLCs also offer flexibility in the management of the entity, as the members may choose to manage the entity themselves, or delegate management to a manager. Additionally, unlike corporations, LLCs do not require strict governance procedures (e.g., annual meetings). These features make the LLC especially suited for family-owned farms, real estate investments, and small enterprises.
- Filings: Articles of Organization must filed with the Secretary of State to form the entity. Additionally, a Statement of Information must be filed biennially with the Secretary of State.
- Liability: Generally, LLC members enjoy limited liability, meaning they are not personally liable for any obligation or liability of the entity.
- Tax: Like a partnership, income of the LLC is passed through to the members, which is reported on the members’ tax returns.
5. C Corporation
A c-corporation is a legal entity separate from its owners, directors and officers. It offers limited liability protection to its shareholders, with management vested in a board of directors. Corporations generally require more formality as compared to other business entity forms, such as annual board and shareholder meetings. Such formalities may be overly burdensome for smaller, family-owned businesses.
- Filings: Articles of Incorporation must be filed with the Secretary of State to form the Entity. A Statement of Information must be filed annually with the Secretary of State, which includes information about the corporation’s directors and officers.
- Liability: As mentioned above, assuming corporate formalities are properly followed, shareholders generally enjoy protection from personal liability. Additionally, directors, officers and employees ordinarily do not have personal liability for the corporation’s debts or obligations.
- Tax: A downside to the corporate entity is the concept of double-taxation. First, the corporation itself is subject to the corporate tax. Dividends are then taxed again at shareholders’ level. However, shareholders may enjoy pass-through taxation by electing that the corporation be treated as a Subchapter S corporation (“S-Corp”). This election places certain restrictions on the corporation (e.g., the number of shareholders cannot exceed 100 and the corporation may not have more than one class of stock).
Given the complexities and consequences of business entity structure, care should be taken to select the form of entity best suited for your business
Disclaimer
This Legal Update / Bulletin is for educational purposes only as well as to give you general information and a general understanding of the law, not to provide specific legal advice. This update should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.
Authors
Matthew E. Hoffman, Shareholder
Haley M. Georgouses, Associate
