Choosing a Business Entity
Short Answer:
Most modern businesses would be best served by an LLC structure. The exceptions are (1) businesses seeking to attract a particular type of funding early on in their growth, (2) business planning on going public within three to five years, (3) businesses providing licensed professional services in states where licensed professionals must incorporate, and (4) California state-licensed contractors. The latter four companies will likely be better served by incorporating.
Not only will your choice of entity affect the structure, operation, and tax liability of your business, your choice of entity dictates the extent to which your personal assets are protected.
There are six basic entities commonly used to structure a new business. They are the sole proprietorship, general partnership, limited partnership, limited liability partnership (LLC), limited liability company (LLP), and the corporation (Inc.).
1. Sole Proprietorship
The oldest business entity is the sole proprietorship. If you own your business as an individual and have not filed any documents with the Secretary of State, you are operating as a sole proprietorship. As with every business structure, the sole proprietorship comes with its own set of pros and cons. The strengths of a sole proprietorship are flexibility, pass through tax liability, simplicity, low cost of formation and elegance of management. The weakness of a sole proprietorship, however, is significant. If you own a sole proprietorship, your personal assets remain unprotected and can be attached should anyone secure a judgment against your company. It should be noted, however, that if you are a new business, many institutions with whom you do business with will require you to personally guarantee any debt incurred by your company even if you are an LLC or corporation. As such, status as a sole proprietorship generally only creates more personal exposure of your personal assets than an LLC or corporation with clients, customers and those vendors not requiring a personal guarantee. There are clauses that can be utilized in your client and customer service agreements to minimize this exposure. Thus, if you prefer to operate your company as a sole proprietorship, at least in the beginning, you should seek legal advice regarding the terms of your client or customer service agreements.
2. General Partnership
Similarly, if you operate your business with another individual or other individuals, but have not entered into a written agreement or filed documents with the Secretary of State, you are a general partnership. In the absence of an agreement between partners, the Revised Uniform Partnership Act governs a California partnership. In a general partnership, all of the partners remain personally liable for the debts and obligations of the partnership. Thus, like the sole proprietorship, the general partnership offers no protection of the personal assets of the partners. Also, like the sole proprietorship, a general partnership also offers pass-through tax liability, low cost of formation, and flexibility. If you are a partner in a general partnership, you are strongly advised to, at the minimum, enter into a partnership agreement with your other partner(s). There are innumerable cases that have been litigated involving a partnership gone bad, many of which could have been avoided if the partners had actually sat down and put on paper the terms of their agreement. In many cases, this simple act can reveal that the partners were not actually on the same page regarding some material terms, giving them an opportunity to work it out before the company becomes profitable and there was a pot of money to fight over.
3. Limited Partnership
Third, we have the limited partnership. In a limited partnership, the limited partners are liable for the obligations of the company only to the extent of their investment in the same. The limited partners are generally passive investors who do not have an active role in the management of the company's affairs. The general partners remain liable for the debts and obligations of the company.
4. Limited Liability Partnership
Fourth, but seldom used, is the limited liability partnership (LLP). This entity requires the filing of documents with the Secretary of State and allows for the protection of the personal assets of the partners. In most other ways, it resembles a general partnership, allowing for pass-through tax liability and flexibility of management. The partners can run the business themselves, have protection for their personal assets and incur tax liability as if they were each operating their own sole proprietorship. This entity is not frequently utilized because the LLC, which was developed after the LLP, offers many of the same benefits with more flexibility and is generally more attractive to investors.
5. Limited Liability Company
The limited liability company (LLC), is one of the most common choices for business entities among newly formed businesses. The LLC offers protection of personal assets, significant flexibility in the management, ownership and operation of the company, and pass-through tax liability. The individuals with an ownership interest in an LLC are referred to as members, with one or more members being designated as the managing member. The biggest drawback for many small companies is the annual fee for maintaining an LLC ($800 in California). However, the benefits conferred by the LLC structure far outweigh this cost, which is minimal if the company becomes profitable. While it is not required that an LLC prepare and sign a written operating agreement, it is strongly advised that you do. Again, innumerable cases that involved a business relationship gone “bad” have been litigated, most of which could have been avoided if the parties had actually sat down and put on paper the terms of their agreement. In many cases, this simple act can reveal that the owners were not actually on the same page regarding some material terms, giving them an opportunity to work it out before the company becomes profitable and there was a pot of money to fight over.
6. Corporation
The corporation is frequently formed for many of the same reasons that an LLC is used. Forming a corporation requires the filing of documents with the Secretary of State as well as payment of a fee. Similarly, it also offers protection of your personal assets. However, the documents that must be filed and maintained to form a corporation are not as simple as the document required to form and maintain an LLC. Thus, many clients prefer the simplicity and flexibility of an LLC to the more cumbersome and rigid corporation.
Tax-wise, becoming a corporation can result in greater tax liability, depending on the type of corporation you select, whether an S Corporation or a C Corporation. It is possible, however, to set up your corporation for status as a pass-through entity for tax purposes. Some people are of the opinion that a corporation is the entity of choice for would-be investors. However, this is debatable, as an LLC is also generally attractive to investors. Obviously, if you have any intention of one day going public, you will need to be a corporation at that time, but conversion at a later date is usually a manageable cost in exchange for the ease of maintaining an LLC in the interim.
(It should be noted that if you are providing services of a licensed professional, you may have to file as a professional corporation or LLC, depending on what is available in your state.)
Where should you form your company?
Short Answer:
You should file either in your home state, or in Delaware if you’re willing to pay a premium for its benefits, the value of which varies depending on circumstance (but in truth is seldom worth it).
New business owners frequently ask whether they should form their entity in their home state, Nevada (*allegedly* lower taxes), Delaware, or somewhere else. The answer depends on your particular circumstances. Generally, you want to form your entity in either (1) your primary location/home state, or (2) Delaware. It likely won’t benefit you to file in a “cheaper” state, because many states – like California – will require you to qualify to do business in the state in which you’re located (which means paying their minimum tax regardless). Thus, you end up paying business taxes in two states, rather than just the cheapest state.
Some business owners prefer Delaware because (1) filing is simpler, faster and more seamless, (2) Delaware law favors management rights, whereas the laws in California (and some other states) favor shareholder rights, and (3) Delaware has a dedicated court for business disputes that – in theory – better serves businesses. Filing in Delaware, however, will not save you from also having to file and pay in your home state, so you pay a premium (double the annual fees) to file there.
What other documentation/licenses do you need?
Short Answer:
You likely need a local business license, possibly a DBA, and possibly an industry-specific license.
In addition to the charter documents necessary to form a corporation, LLP or LLC, you may also need to file for a local business license. The costs associated with such vary from city to city so you should speak to counsel regarding your obligations in this regard. (Some cities don’t regularly enforce this, meaning that if costs are tight, you may be able to put it off for a year or two.)
You may also want to file a Fictitious Business Name (“FBN”) also referred to as a Doing Business As (“DBA”) if you plan on using a trade name other than your business name or your personal name. An FBN can also be useful in the event that you change entity-types, sell part or all of your business, or change business names. In these instances, an FBN can allow you to continue doing business under the same name, without alerting the public to internal changes within the company.
Finally, your business may require industry-specific licenses, as it does for doctors, lawyers, contractors, etc.
