Before starting a business in California, you must decide which structure the company will take. For example, should you structure your new business as a C or S corporation, Partnership, limited liability company (LLC), or something different?
The answer you choose is crucial because your business entity selection will have lasting financial and liability ramifications – not only with regard to how your business operates but also, to how it is taxed and regulated. It is also relevant for liability purposes. Some entities do a better job of insulating your personal nonbusiness assets in the event of a lawsuit than others. Each structure has unique advantages and disadvantages when it comes to liability protection, ease of operation, taxation characteristics and overall flexibility.
Read on to learn more about the tax treatment of different entity types, then consult the experienced business tax attorneys at the Tax Law Office of David W. Klasing for accounting and legal assistance. Representing corporations, LLCs, partnerships, and sole proprietorships, we can guide you through a detailed entity comparison, enabling you to make savvy, strategic decisions in support of your financial goals.
What Types of Business Entities Are Recognized in California?
There are four basic types of business entities that may be formed in California: (1) corporations; (2) limited liability companies; (3) partnerships; and (4) sole proprietorships. These categories are further subdivided as follows:
- Corporations
- C corporations
- S corporations
- Professional Corporations
- Limited Liability Companies (LLCs)
- LLCs that elect to be taxed as partnerships
- LLCs that elect to be taxed as corporations (C or S)
- Single member LLC’s treated as disregarded entities for federal purposes
- Sole Proprietorships (Schedule C business)
- Partnerships
- General partnerships (GPs)
- Limited partnerships (LPs)
- Limited liability partnerships (LLPs)
Note: Depending on where your business is founded, there may be a fourth option, known as the “limited liability limited partnership” (LLLP). However, an LLLP may only be formed in certain states, which presently exclude California. Out-of-state LLLPs may do business in California, but not before registering with the California Secretary of State (SOS).
What Are the Advantages and Disadvantages of a Sole Proprietorship?
The advantages of a sole proprietorship include the following:
- Ease, expense and simplicity of use, formation, and termination
- No burdensome requirements for documenting minutes or meetings
- No additional tax return to file (meaning the sole proprietor will pay taxes on business income when filing his or her personal income tax return on Schedule C)
The disadvantages of a sole proprietorship include:
- General lack of business continuity (meaning the entity ceases to exist when the owner dies)
- Inability to bring on new or additional owners without changing the entity – for instance, joining with another taxpayer to form a partnership
- Limitation on available pension plans
- Potential financial danger resulting from unlimited personal liability in the event of a lawsuit.
What Are the Advantages and Disadvantages of a Partnership?
The advantages of a partnership include:
- Flexibility of operation
- Ease of formation and termination
- Ability to use a Section 754 election, which, under 26 U.S. Code § 754, enables “the inside basis of partnership property in certain situations… [to] be adjusted upward which can result in higher depreciation deductions and lower capital gains to the affected partner”
- In many cases, partnerships also benefit from partners who possess complementary skills
- Special tax allocations for partnerships, which enable partners to control and customize the advantageous allocation and distribution of profits and losses
- Unreimbursed partnership expenses may be deducted, subject to certain criteria with a properly drafted partnership agreement
- Partners get an increase in basis where the partnership takes on recourse debt.
The disadvantages of a partnership include:
- Potential for partnership disputes and disagreements – sometimes, resulting in the breakup of the business
- Unlimited liability in which general partners can become personally liable for the actions of other partners (GPs)
- Accounting, tax and legal complexity
Readers may be interested in the following for more information about business partnerships:
- Are U.S. partners in a foreign partnership taxed?
- What is the difference between general partnerships, limited partnerships, and LLPs?
- What will happen to my partnership interest in a divorce?
What Are the Advantages and Disadvantages of a C Corporation?
The advantages of a C corporation include:
- Limited liability of shareholders personal assets in the event of a lawsuit
- Perpetual life
- Ability to raise capital through the issuance of stock
- Ease of transfer of ownership
- Advantages pension planning
- 21% Corporate tax rate
- Tax free mergers and spin offs
- Legal certainty via case law dating back to English Common Law
The disadvantages of a C corporation include:
- Double taxation on profits (i.e. once at the corporate level and a second time at the individual level with the payment of dividends to shareholders).
- Lack of flexibility, such as corporate charters that restrict certain types of business activities
- Intense regulation with numerous state and federal controls, such as requirements to keep corporate minutes
- C Corporations do not enjoy lower capital gains rates
A corporate tax attorney from the Tax Law Office of David W. Klasing can help you navigate these issues successfully in a business tax landscape that has been radically altered by the Tax Cuts and Jobs Act (TCJA).
What Are the Advantages and Disadvantages of an S Corporation?
The advantages of an S corporation, which is also known as a “pass-through” or “flow-through” entity, include the following:
- Limited liability for owners and shareholders (potential protection of shareholder non-business personal assets if the corporate veil is not pierced during a lawsuit)
- Perpetual life (though the company may be acquired by another entity)
- Ability to raise capital by issuing stock
- Avoidance of the double-taxation obstacles facing C corporations (single level of tax with flow through of corporate profits to the individual shareholder’s personal tax returns)
- Profits “passed through” are not subject to self-employment (SE) tax
- Ease of transfer of ownership
The disadvantages of an S corporation include:
- Less flexibility in choosing a tax year (Generally has to have 12/31-year end)
- Unreasonably low compensation audit exposure (Shareholders are required to be reasonably compensated via form W2 for their own labor contributed to the S Corp.)
- Limited flexibility with regard to the allocation of losses and profits to individual shareholders (Disproportionate distribution of profits can invalidate the S Corp. election)
- Limited number of shareholders (100 maximum), potentially restricting the company’s growth
- Prohibitions against ownership by non-resident aliens
- Potential for involuntary termination of S corporation status (which may be restored, subject to IRS approval)
- Built in gains tax exposure where a C Corporation is converted to an S Corporation
- S Corporation Shareholders do not get an increase in basis where the S Corporation takes on debt.
What Are the Advantages and Disadvantages of a Limited Liability Company (LLC) Taxed as a Partnership?
Though not appropriate for every business plan, the LLC is the most popular type of entity today. The advantages of an LLC include:
- Avoidance of certain restrictions that limit corporations
- Avoidance of double taxation (profits “pass through” to LLC members)
- Like a partnership, an LLC usually benefits from members who contribute complementary skills
- Disproportionate distributions and allocations of income may be possible
- Members get an increase in basis where the LLC that is taxed as a partnership takes on recourse debt.
The disadvantages of an LLC include:
- Disagreements in decision-making can cause costly delays and disruptions
- Potential for disorganization without a robust operating agreement
- The LLC’s existence may end if one of its members leaves the company
- LLC taxed as a partnership taxed on gross receipts for California purposes and not on net profit which may result in California tax liability even where incurring a net operating loss.
Note that single-member LLCs, or, as the IRS calls them, “disregarded entities,” are generally treated as sole proprietorships for federal tax purposes, unless the LLC files Form 8832 (Entity Classification Election), which will result in the LLC being treated as a C or S corporation.
