One of the most important initial decisions to be made regarding a business enterprise is the choice of its form of legal entity. While a business can certainly be conducted as a sole proprietorship or in a general or limited partnership, for reasons of limited liability of owners and ease of operation, the most popular choices are a limited liability company (“LLC”) or a corporation. But which entity is right for your business enterprise?
To make the right choice, a business owner needs to consider the factors that distinguish legal entities from one another and determine how the balancing of those factors may best benefit the proposed business enterprise. The primary distinguishing factors to be considered, and how they relate to the choice of an LLC or a corporation in California, are summarized in the following table.
|
Factor |
LLC |
Corporation |
|---|---|---|
|
Formalities and procedures for forming and organizing the entity. |
Formed by filing articles of organization with the Secretary of State. Statute contemplates that the members will enter into an operating agreement to govern operations, management and transferability of membership interests. Note: Licensed professions (other than licensed contractors) may not operate in LLCs. |
Formed by filing articles of incorporation with the Secretary of State. Operations are governed by elaborate statutory rules, including requirements for periodic meetings and maintenance of corporate records. |
|
Manner in which the entity facilitates capital requirements. |
Membership interests may be sold to raise capital; operating agreements may provide for mandatory calls on members to contribute capital. |
Stock may be sold to raise capital. |
|
Rights of owners to participate in management of the entity. |
Members may reserve management powers to themselves or may have centralized management through the appointment of managers. |
Management is centralized in a Board of Directors elected by shareholders. The Board selects officers to operate the business on a day-to-day basis. |
|
Allocation of profits and losses among owners. |
Operating agreement may provide for custom allocations. |
Pro rata in accordance with shareholdings. |
|
Personal liability of owners. |
Members and managers enjoy limited liability from entity obligations. |
Shareholders enjoy limited liability from entity obligations. |
|
Ability to transfer ownership interests. |
Consent of members is generally required to transfer membership interests. |
Stock may be transferred without disruption of the business. Shareholders may enter into shareholder agreements to make buy-sell arrangements, address voting rights, and limit transferability of stock. |
|
Effect of death, withdrawal or retirement of an owner. |
Death or withdrawal of a member generally does not cause dissolution. The effect of these events are typically addressed in the operating agreement. |
No impact on the continuity of the business. The effect of these events are typically addressed in shareholder agreements. |
|
Tax consequences and opportunities. |
Generally taxed as partnerships (including self-employment tax), but a single member LLC is taxed either as a sole proprietor or a corporation. Subject to annual LLC Tax of $800, plus annual LLC Fee based on gross receipts of: at $250K+, add $900, at $500K+, add $2,500, at 1MM+, add $6,000, and at $5MM+, add $11,790. |
C corporations are subject to “double taxation” – on corporate income and then on shareholders for distributions received, but can provide tax-free fringe benefits to owners. S corporation status may be elected to provide a single level of tax at the shareholder level; however, shareholders must generally be individuals, the corporation can only issue a single class of stock, and tax-free fringe benefits to owners are limited. |
As noted above, the choice of an LLC or a corporation as the form of entity for a business requires a balancing of tax and non-tax factors. The appropriate form should provide a means for owners to achieve their desired results without unduly constraining their freedom of action. Owners are encouraged to solicit input from their accountant, attorney and other professional advisors before launching a new business entity to assure that the entity is appropriately structured and organized. Such an early investment can ultimately save a lot of time and expense in fixing or converting an inappropriate entity formed through an on-line service by a few clicks of a mouse.