Page | 1

Forming and Operating A Business

The big concerns when choosing an entity type for your business

- Limiting your liability as an owner- Tax burden- Complexity of management

4 basic types of entities:

Sole Proprietorship. Default when one person (or spouses) begin operating a business.

Partnership. Default business when two or more people begin operating a business.

Limited Liability Company (LLC). Filed with the Secretary of State (flexible and typically informal management structure). Business requiring state licenses cannot form LLCs (for example: attorneys & doctors, contractors, real estate agents, etc. If you are licensed but not sure if this applies to you, contact your licensing board).

Corporation. Filed with the Secretary of State (rigid and typically formal management structure).

Special types: Limited Partnerships (has “limited” partners who do not manage the business); Limited Liability Partnerships (for attorneys, architects & accountants); Professional Corporations (for professions licensed under the Business & Professions code- such as attorneys, accountants, medical professionals); Close Corporations (fewer than 30 shareholders, can elect to be run informally under a shareholder agreement).

Limiting Liability

Liability means the owner’s legal liability for the actions and obligations of the business.

Non-limited liability entities include sole proprietorships and general partnerships.

- In these entities, the business and the owner(s) are considered one and the same under the law.

- Property “owned” by the business is actually owned by the owners.

- In a lawsuit, a judgment against the business is a judgment against the owner and the owner’s non-business assets (personal residence, paychecks from other jobs, etc.) can be seized/garnished/foreclosed on to satisfy the judgment.

- In a partnership, all partners are liable for the actions of any partner.

Limited liability entities include corporations and LLCs. The owner’s liability is “limited” to the owner’s capital investment in the entity.

- The business is considered a separate legal person under the law

- The business itself can hold title to assets and property

Page | 2

- In a lawsuit, the business can sue and be sued in its own name- owners can only be sued for the entity’s business activities under the “alter-ego” doctrine (aka “piercing the corporate veil”). A judgment against the business can only be satisfied by assets owned by the business, not the owner’s personal assets.

Limited Partnerships- a partially limited liability entity. This is a partnership where “silent” partners (investors) receive limited liability while “general” partners (who run the business) don’t.

Limited Liability Example: Debbie owns a flower shop. She has an employee who delivers flowers in a company van. On a delivery, the employee runs a red light and hits another car. The other driver files a lawsuit.

If Debbie is a sole proprietorship…

Debbie will be personally sued for the accident. The plaintiff can go after Debbie’s business and personal assets to satisfy the judgment.

If Debbie owns a Corporation called Debbie’s Flowers, Inc.…

Debbie’s Flowers, Inc. will be sued. The plaintiff can only go after assets owned by the corporation.

Tax Burden

Types of Tax:

Pass Through Taxation = the business’s profits pass through to the owner. The business earns money, pays its business expenses and has a net profit.

Pass Through Tax applies to Sole Proprietorships, Partnerships, LLCs (default) and S-Corporations (must file an election with the IRS)

Corporate Taxation = the business pays taxes on profits and the owners pay taxes on distributions/dividends paid out by the business (“double taxation”).

Corporate Tax applies to C-Corporations (default) and LLCs (must file an election)

Franchise Tax = the annual California tax on limited liability entities. The minimum is $800/year.

Management

Ownersown interests and receive profits

Managers control the actions of the business

Sole Proprietorship Sole Proprietor Sole Proprietor

PartnershipGeneral Partners and Limited Partners

General Partners

Page | 3

LLC Members ManagersCorporation Shareholders Directors, Officers (CEO etc.)

In a small business, owners are often also managers, but they don’t have to be!

Sole Proprietorship: Very informal, the owner is the ultimate manager, but can delegate operations to employees.

Partnership: General partners are all agents of the partnership and can bind the partnership.

LLC: Run either by all Members (“member-managed”) or by a Manager(s) appointed by the Members (“manager-managed”). Governed by an Operating Agreement. It can (and often is) run like a partnership.

Corporation: Shareholders annually vote on the Board of Directors. Directors annually appoint the Officers- president, secretary, treasurer and vice-presidents (optional). California law requires at least 3 directors unless there is only 1 or 2 shareholders (in which case you only need 1 or 2 directors respectively).

A single-shareholder corporation can have the shareholder act as the sole director, and hold the title of president, secretary and treasurer.

Equity versus Debt

Businesses can raise money by having equity investors or through loans.

Equity investors contribute capital in exchange for an ownership interest in the business. If the business fails, the equity investor looses the investment. If the business thrives, the investor’s return is based on a percentage of profits.

Follow SEC disclosure rules! Consult an attorney early in the process.

Page | 4

Lenders loan capital to the business on set terms (usually a repayment schedule with an interest rate). If the business fails, the lender is still owed repayment of the loan. If the business thrives, the lender’s return is set by the terms of the loan.

Setting Up a Business

All Businesses:

Contact your city about city taxes/permits

Obtain a reseller’s permit if you will be selling any products to end consumers (not wholesale)

Obtain an EIN from the IRS (you can do this online at www.irs.gov)

If you have non-owner employees, obtain an Employer ID number from the Franchise Tax Board (www.ftb.ca.gov) and obtain workers compensation insurance (it’s required!).

Sole Proprietorships: nothing fancy required, it’s easy, it’s the default!

Will need to file self-employment taxes on business profits.

May be required to make quarterly estimated tax payments. Talk to an accountant early on!

Partnerships:

Should have a partnership agreement drafted that governs the relationship between partners. Otherwise Uniform Partnership Act rules apply as a default.

Must file a K-1 Form 165 with the IRS on partnership income and make sure all partners receive a copy. You may be liable for self-employment tax and estimated tax payments.

Page | 5

Limited Partnerships need to file a Certificate of Limited Partnership with the Secretary of State (www.sos.ca.gov/business) along with a $70 fee. Responsible for the annual franchise tax.

LLCs:

Must file Certificate of Organization with the Secretary of State (www.sos.ca.gov/business) along with a $70 fee.

Must have an Operating Agreement drafted that governs the relationship between members and managers.

Must file biennial statements of information with the Secretary of State along with a $20 fee. First statement should be filed within 90 days of inception!

Must pay the annual franchise tax to the Franchise Tax Board (first year this may be due four months after inception)- may be required to make quarterly estimated payments.

Corporations:

Must file Articles of Incorporation with the Secretary of State (www.sos.ca.gov/business) along with a $100 fee.

Must have By Laws drafted that govern the relationship between shareholders, directors and officers. Draft the organizational minutes appointed directors and officers.

Must file annual statements of information with the Secretary of State along with a $25 fee. First statement should be filed within 90 days of inception!

If electing S-Corporation status, must file form 2553 within 2 months and 15 days after inception!

Must pay the annual franchise tax to the Franchise Tax Board

Annually hold a shareholders meeting followed by a directors meeting. Should be properly noticed and held on the appropriate date and time per the bylaws.