In California, a business owner can choose among a variety of business structures, each with their own advantages and disadvantages. The most common forms of business entity are the Sole Proprietorship, the Corporation, and the Limited Liability Corporation (or “LLC”). Our office typically does not recommend the use of General Partnerships, because it makes you personally liable for any contracts entered into by your partner(s).
The simplest form of business entity is the sole proprietorship. This is a relatively informal entity – it takes very little time or money to establish, but offers no limitation of personal liability or income tax advantage. However, a sole proprietorship is not required to pay the $800 minimum tax to California’s Franchise Tax Board, so it is often a good choice for newly-established or secondary/side businesses. In many cases, personal liability is not an issue for owners of sole proprietorships because they are able to mitigate any potential losses with adequate insurance coverage.
Income derived through a sole proprietorship will subject the owner to federal self-employment tax. For self-employment income earned in 2013 and 2014, the self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance). For income earned in 2014, the first $117,000 of your combined wages, tips, and net earnings are subject to any combination of the Social Security part of self-employment tax, Social Security tax, or railroad retirement (tier 1) tax. All your combined wages, tips, and net earnings in the current year are subject to any combination of the 2.9% Medicare part of Self-Employment tax, Social Security tax, or railroad retirement (tier 1) tax.
If you will not be the sole owner of your new venture (or even if you will be), you should also consider forming a Corporation or Limited Liability Corporation.
For many small businesses, the preferred corporate structure comes in the form of a Subchapter S Corporation, more commonly known as an S-Corp. A Subchapter S Corporation is a distinct legal entity separate from the owners, and thus serves to shield owners from personal liability in most cases. Additionally, it offers tax advantages as to self-employment tax if operated properly. The profits and losses derived by a Subchapter S Corporation flow through to the owners as if they were partnership distributions – a Subchapter S Corporation owes no federal tax at the corporate level. For state tax purposes, corporations that qualify for and elect to be taxed as an S-corp are taxed at 1.5% of their net profit, for the first year, and the greater of 1.5% or $800 per year for every year after that. Estimated taxes are paid quarterly.
There are many restrictions that can eliminate Subchapter S Corporations as a viable option for some businesses. Non-resident aliens may not have an ownership share in a Subchapter S Corporation, and a Subchapter S Corporation may not have more than 75 owners. Additionally, the owners of Subchapter S Corporations can only be individuals or certain trusts. With a Subchapter S corporation, each owner has the same percentage of ownership, voting power, and profits and losses. If you want different percentages of ownership share or voting power, a “C” Corporation or Limited Liability Corporation would be better options. If your business derives more than 25% of its income from passive investments, the Internal Revenue Service can terminate your Subchapter S status, making a Subchapter S Corporation a poor choice for real estate businesses.
Like a Subchapter S Corporation, a “C” Corporation limits the potential for personal liability.
If significant business revenue may need to be transferred from one year to the next or if the need to offer extensive fringe benefits, such as health insurance, is likely organizing as a C Corp may be appropriate.
This is becasue a C Corp permits certain benefits to be deducted from the corporations taxes. For instance, although employer remittances for health benefits is not included in the employee’s gross income, the payments are tax deductible for the business. Other employer expendatures that can receive similar treatment include benefits for:
- life insurance
- supplementary unemployment
- child care
- travel lodging and meals
- employee mass transit
- employee parking
The primary downside to a “C” Corporation is that any profits or dividends paid are subject to double taxation. In businesses with passive investors, it is highly likely that such distributions will be expected and there may be better tax planning options available. For state tax purposes, “C” Corporations are taxed at 8.84% of income the first year and the greater of 8.84% or $800 for each year after that. Estimated taxes are paid quarterly.
Limited Liability Corporations
The Limited Liability Corporation (or “LLC”)will protect your personal assets from business liabilities like a corporate form of organization would. One advantage of an LLC over an S or C Corp is that their are significantly fewer formalities involved in an LLC’s management and administration.
LLCs represent a synthesis of the pass-through taxation benefits that can be provided by a partnership or sole proprietorship and the risk insulation features typically associated with a corporate form of organization. The pass through benefits of an LLC allow a business owner to avoid the double taxation that occurs with corporate profits. Since the LLC is not an individually taxable entitiy, both increases and losses can be passed through to the owner’s individual tax return.
Aside from the tax benefits, owners of an LLC have their personal assets protected much as a corporation’s owners are provided the same benefit. In short, their liability is limited. Owners (technically called “members”) of a Limited Liability Corporation can deduct all losses (while owners of Subchapter S Corporations may only deduct losses to the extent of their investment), and members can have varying degrees of ownership share and voting power without losing pass-through taxation capability. The owners/members of an LLC may be entities, such as other LLCs or corporations.
An LLC may be taxed as an entity or may elect “pass-through” taxation, from year to year. On the state level, LLCs are taxed a minimum of $800 per year at the end of the first quarter. However, if the entity elects to be treated as a corporation, it will file Form 100 (and 100-ES) and pay taxes as a corporation. Although the tax is progressive in nature, the average LLC tax percentage is approximately 1/4 of one percent of revenues. . Estimated taxes are paid quarterly.
In California, many professional services are not permitted to operate through a Limited Liability Corporation. Under California Corporation Code § 17375 professionals credentialed under the California Chiropractic Act, California Business & Professions Code or the California Osteopathic Act, are not permitted to form as an LLC. Affected professions include attorneys, physicians, licensed contractors, CPAs and accountants, and others.
Specifically, Cal. Corp. Code Sec. 17375 prohibits LLCs from rendering “professional services”. “Professional services” are defined in California Corporations Code Sections 13401(a) and 13401.3 as “any type of professional services that may be lawfully rendered only pursuant to a license, certification, or registration authorized by the Business and Professions Code, the Chiropractic Act, the Osteopathic Act or the Yacht and Ship Brokers Act.” If you fall under one of these categories, your best bet would probably be to form a Limited Liability Partnership or a Professional Corporation, depending on the circumstances of your particular business. Contact our office to learn more about which entity would be best for your new venture, and whether you are eligible to operate as an LLC under California law.