When starting a business or making material changes, the type of business entity you chose may be critical to maximize profits. The normal business choices are sole proprietorship, corporation or limited liability company.
A sole proprietorship is you owning and managing your business using your name or a fictitious business name. Just start an activity that generates revenue and expenses and you are in business. The revenue and expenses are yours. You will file your federal income tax return, form 1040, with a schedule C showing the income and expenses and pay taxes on any profits or deduct net losses from other income. The biggest problem? The expenses and liabilities are yours. You may not want that risk.
Corporations provide a shield for you and your assets from business liabilities. You must create the corporation properly and maintain corporate amenities. That means filing proper articles of incorporation with the Secretary of State, issuing stock with proper filings with the Department of Corporations, holding at least annual board of director and shareholder meetings where you review past and future business activities and resolve approval or rejection of such activities. You must keep all business/corporate activities separate from your personal activities. You may have as many members of the board as you like. Be sure to look into director insurance. But what about the taxation of the profits or losses? When you create a corporation, it becomes a “C corp” by default so all profits or losses belong to the corporation. But, shareholders may elect with the IRS to become a sub-chapter “S corp” so the net tax impact of profits or losses will be shared by shareholders pro-rata per their stock ownership. Much like a partnership, the net annual profit/loss will be reflected on a Schedule K-1. There are many more details about corporations that allow much flexibility in financing, equity, establishing multiple businesses, obtaining outside business advice, etc.
The limited liability company has many advantages of the corporation regarding the liability shield, financing, tax alternatives, etc. But, it streamlines the management structure and eliminates many of the internal formalities, such as you need not have annual or any other record of meetings. In fact, an LLC does not have directors or shareholders, it has members and one or more managing members. The managing members and members rights and duties are contained in an agreement that establishes the organization of the LLC, or to the extent that such agreement does not cover some issue that may arise in California the Corporations Code provides many default provisions. The LLC will elect to be taxed as a “C” corporation or a partnership. If the LLC has only one member, the election as a partnership will accommodate the single member to file each annual profit or loss on IRS form 1040, schedule C, like a sole proprietor.
The above summary provides minimum information regarding what type entity may hold your business. Your tax accountant will be a necessary party to your decision. Chris Schaefer is available to provide more customized legal advice on which entity is appropriate for you: (415) 454-2421 or chriss@caschaefer.com