When Starting a Business, Choose Your Entity Wisely!

Guest Blogger Jessica T. Olmon, Vero Law Group

As a lawyer who works with entrepreneurs, I know the early stages of setting up your business can be thrilling.  Successful entrepreneurs are energized and often want to move as quickly as possible to begin operations. They may also have limited cash and try to save by choosing a corporate structure on their own.

However, I’ve seen businesses lose hundreds of thousands of dollars in the long run using this mentality.  In the rush to get started, they didn’t set up the correct kind of business, or in legal terms, they didn’t choose the correct entity.

So what do you need to know to choose wisely? Here’s how I break it down.

Proprietorships and Partnerships: Assets at Risk

Many people starting out in business begin as a sole proprietorship. There are very few legal requirements for a sole proprietorship, though depending on what you call your business, you may have to file a fictitious business name statement. On the plus side, there are no registration requirements with the State of California.

However, this also means that legally there is no separation between you and your business. In other words – your assets are at risk. Your sole proprietorship’s liabilities are YOUR liabilities, which means if your business has a liability to someone else (because of a lawsuit or some other issue), you can lose your house, your car, the money in your bank accounts or any other asset that you own personally.

The same is true for a partnership. Partnerships are very similar to sole proprietorships, but they are a business between two or more people. If you form a partnership, it is extremely important to have a written agreement between all parties. But remember, just like a sole proprietorship, everyone involved in a partnership will have their personal assets at risk if the business has a liability.

If you are a sole proprietorship or partnership, you’ll eventually want to convert into one of the following structures to protect your assets and make room for growth.

The Limited Liability Company (LLC): Appealing Simplicity

A limited liability company (LLC) protects your assets, and you have no personal liability as long as you are running your company correctly. There are registration requirements, a setup fee and an annual fee in California in exchange for the right to have an LLC. For the purposes of the law, an LLC is a separate entity.

The simplicity of an LLC makes it an attractive option for many business owners. It has a very flexible structure that can be modified when partners have different financial situations. However, from a tax perspective, the default rule is that there is no distinction between what your LLC makes and what you make. So if an LLC makes $100,000 profit in a year, the owners will be personally taxed on that $100,000 whether or not they receive distributions from the company.

Another thing to consider – California has a gross receipts tax for any LLC that grosses more than $250,000 per year. Depending on your business revenues, this tax may make an LLC a less viable option.

 The Four Basic Corporate Structures

Corporations are probably the most well-known corporate entity. Corporations exist as a separate entity, which again, protects your personal assets from business liabilities as long as you are running the company properly. Corporations are required to have an annual board of directors’ meeting and a shareholders’ meeting.

Here are four types of corporations.  It is important to note that you can have an S corporation that is also a B corporation so I will review these to give you an idea of the depth of options when forming your company.

  • C-Corporation: C corporations are taxed twice—first on the net revenue of the corporation and again when the company distributes profits to shareholders. This is the most common kind of corporation among large companies.
  • S-Corporation: S corporations are similar to LLCs in that they are taxed at the shareholder level, not the corporate level. For example, if the S corporation has net revenue of $100,000, and there are four equal shareholders, then each shareholder will pay taxes on $25,000 in income, regardless of how much of that money is actually distributed to the shareholders.  The IRS limits who can be a shareholder of an S corporation.
  • B-Corporation: B corporations are formed to take action for the greater good and also to make a profit. This is a new corporate designation that is available in a few states, including California, which has two types of B corporations, the flexible purpose corporation and the benefit corporation. Successful companies that have transitioned to a B corporation include Ben & Jerry’s and Patagonia. B corporations have some attributes of a C corporation and some attributes of a non-profit corporation.
  • Professional Corporation: This is a special corporate designation for certain licensed professionals, such as lawyers, doctors, nurses or psychologists.

When Choosing an Entity, Hire a Professional

Sound complicated? Well, to be honest, sometimes it is! There are all kinds of considerations to take into account when choosing your entity, such as taxes, legal concerns and making room for projected growth.

Bottom line, it really benefits you to work with a lawyer when choosing your corporate structure. Mistakes in this area can be costly. A great business lawyer will help you choose the right entity and set it up properly. You will have potential tax savings, peace of mind knowing that everything has been taken care of and the ability to hit the ground running as you build your company with an entity that fits your business.

Contact Jessica for with your questions!

Jessica T. Olmon

Vero Law Group

(310) 773-1809

(415) 874-3802