Selecting The Type Of Business Entity

The formation of a business entity in California can take one of several forms:

Sole Proprietorship

A sole proprietorship involves one owner who owns, manages, and controls the business. The profits and losses from a sole proprietorship are reported on the owner’s Form 1040 tax return, Schedule C.

Co-Ownership

Co-ownership occurs where two or more persons enter either an oral or written agreement to jointly own property, which is commonly known as tenant-in-common agreements or simply “TIC agreements.” Profits and losses are generally allocated in proportion to the percentage of ownership of each co-owner and reported on each owner’s Form 1040 tax return. Co-ownership may be best suited for a situation in which a small group of people jointly owns an income-producing asset, such as residential rental property, commercial rental property, or other investment that does not require a substantial amount of active management.

General Partnership

A general partnership is a business entity in which two or more persons operate a business for profit. The disadvantage of a general partnership is that each of the general partners is personally liable for the debts of the general partnership. General partnerships may be oral or written, may specify the percentage of ownership of each member, may specify how profits and losses are to be allocated, may specify the voting rights of the partners, and may specify the rights of partners to withdraw or transfer their interests. Generally, partnerships do not directly pay income tax, but rather file an information return on Form 1065, which allocates items of income and loss to the individual partners on Form K-1. Even a simple general partnership involving two persons who operate a simple business should be set forth in a written general partnership agreement addressing all of the rights, duties, and expectations of the partners, including the manner in which an interest in the partnership might be transferred during the life or at the death of one of the partners.

Limited Liability Company

A limited liability company (LLC) may be formed under state law by the filing of Articles of Organization and may have one member or multiple members. An advantage of a LLC is that, if its affairs are conducted properly, the owners will be insulated from the liabilities of the LLC. If a LLC involves multiple members, it can elect to be taxed as if it were a partnership, and items of income and expense are allocated to the individual members. The members can elect to treat the LLC for tax purposes as if it were a corporation. The affairs of the LLC are governed by an operating agreement, which sets forth the rights and duties of all of the members, including:

  • voting rights
  • the rights to sell or transfer an interest
  • the manner in which a member’s interest might be treated at death
  • the rights to expel a member
  • whether members will be compensated for services provided to the LLC
  • whether the LLC will be managed by a single manager, a team of managers or perhaps by all of the members
  • the manner in which profits and losses will be allocated and distributed to members
  • and other factors related to the management of the business and the interest of the members.

Corporation

A corporation may be formed by filing Articles of Incorporation and by the adoption of bylaws, which are the governing rules as to the manner in which the corporation is operated. Corporations usually have a president, vice president, secretary, and treasurer, although one person may hold multiple offices. The affairs of corporations are controlled to a large extent by provisions of the California Corporations Code. As to taxation, a corporation can elect to be taxed at the corporate level, known as a “C Corporation,” or can elect in many situations to be taxed as if it were a partnership, which is sometimes referred to as an “S Corporation,” named after subchapter S of the IRS code. The income of a “C Corporation” could be taxed twice, once at the corporate level as income is earned, then again when earnings are distributed to shareholders and taxed as dividends. Therefore, in most cases, if the corporation and its shareholders qualify, a subchapter S election will be made.

If you have questions concerning your particular situation, then please call our Salinas office at 831-757-5426 during business hours to schedule a telephone conference or office visit, or complete the adjacent form and we will contact you.

An attorney-client relationship is not created between the client and the law firm until the attorney and client execute a written retainer agreement describing the legal work to be performed.

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