Guide to California Business Entities

Introduction

Whether your company is a start-up or an established business, the decision regarding the form of business entity your company operates under is an important one. California recognizes numerous forms of business entities, each with important distinctions. The purpose of this guide is to introduce you to several forms of business entities available in California and briefly discuss their key advantages and disadvantages.

The six major forms of business entities are sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability companies, and corporations. Corporations are by far the most popular form of a business entity and are unique because of the many types of corporations, such as, C-Corporations, S-Corporations, professional corporations, etc.

For most business owners, a trade off occurs between adhering to special statutory formalities, limiting personal liability and maintaining management and control of the business. Additional considerations such as availability of capital, continuity of existence, and taxation also play an important role in choosing the best business entity. Generally, as the formalities increase, personal liability and management and control of the business decrease. Thus, the owner of a sole proprietorship enjoys very few administrative formalities, maintains full management and control of the business, but will be personally liable for the wrongs of the business. Personal Liability Management & Control

Sole Proprietorship

Definition

A sole proprietorship is a form of business in which a single individual carries on a for-profit business as the exclusive owner and decision-maker. While the vast majority of sole proprietorships are operated by single individuals, California recognizes a husband and wife that conduct a business jointly, hold joint title to the business assets, and still come within the definition of a sole proprietorship. Because a sole proprietorship is the simplest form of a business entity, the business owner need not adhere to any special formalities.

Management and Control

With the exception of a business owned by a husband and wife, a sole proprietorship is operated by a single individual; thus, the sole proprietor has exclusive management and control of the business.

Personal Liability

A sole proprietor is personally liable for all obligations and debts of the business. Thus, the business assets and personal assets of the sole proprietor are subject to the risks of the business. Moreover, in California, if the owner is married, the martial community property is at risk and subject to attachment by creditors. If the business is conducted under a name which does not show the owner’s surname or implies the existence of additional owners, the owner is required to file a fictitious name certificate and publish a notice in the newspapers.

Capitalization

There are no rules governing capitalization of a sole proprietorship.

Continuity of Existence

The sole proprietorship continues as long as the sole proprietor desires to operate the business and is legally competent. If the business owner is adjudged legally incompetent, becomes incapacitated, or dies, the sole proprietorship ceases to exist. An owner may sell the business as he or she chooses.

Taxation

A sole proprietor is taxed on business income and may deduct allowable business expenses on his or her personal income tax return.

General Partnership

Definition

A general partnership is an association of two or more persons who operate a for-profit business as co-owners. California defines the term “person” as including individuals, partnerships, corporations, limited liability partnerships and companies, and other associations. Whether a general partnership exists usually depends on the existence of either a written or oral partnership agreement. In the absence of an expressed agreement, a partnership may be shown to exist by examining the intention of the parties to conduct business as co-owners.

A “joint venture” is similar to a general partnership with the distinction that a joint venture is formed to accomplish a particular transaction, whereas a general partnership is a continuing entity for an indefinite or fixed period of time. For all practical purposes, general partnerships and joint ventures are treated without significant distinction.

Management and Control

General partners share equal management and control of the partnership, subject to their partnership agreement. Thus, a partner’s power to manage and control the partnership may be limited by the agreement.

Personal Liability

General partners are personally liable for partnership debts, and this liability is not limited to their proportionate share of the partnership. Because each partner is “jointly and severally” liable for the partnership’s debts, a creditor may collect 100% of a partnership debt from a single minority partner. This risk of personal liability is enhanced by the fact that each general partner is deemed the agent of the partnership in dealings with third persons in the conduct of partnership business. However, a partner may seek indemnity from the other partners for their proportionate share of the debt in accordance with the partnership agreement. If the business is conducted under a name which does not show the owner’s surname or implies the existence of additional owners, the owner is required to file a fictitious name certificate and publish a notice in the newspaper.

Capitalization

A general partnership is simply a form of co-ownership of business assets by two or more persons. There are no specific rules on capitalization.

Continuity of Existence

A partnership does not have a reliable continuity of existence in comparison to a corporation. A partnership “at will” is dissolved by the will of at least half the partners. There are other grounds for dissolution of a partnership which generally include events which make continuation of the partnership unlawful or impracticable. Unless otherwise provided by agreement, no one can become a member of the partnership without the consent of all existing partners.

Taxation

A general partnership is not a tax-paying entity and is only required to file an informational return (K-1), showing the income and expenses of the partnership along with each partner’s distributive share. Profits and losses are “passed through” to the partners. All partners must report on their personal income tax returns their distributive share of any profits realized by the partnership, whether or not actually distributed to the partners.

Limited Partnership

Definition

A limited partnership is a partnership with two distinct classes of partners, “general” and “limited” partners. It is a hybrid between a general partnership and a corporation. A general partner has management and control of the organization and will be personally liable for its debts. A limited partner does not participate in the management and control of the organization; therefore, the limited partner’s liability is limited to his/her capital investment in the partnership.

Under California law, a limited partnership is governed by the California Uniform Limited Partnership Act of 2008 (CULPA), with certain exceptions. CULPA requires a limited partnership to file a certificate of limited partnership with the Secretary of State and have a written or oral partnership agreement.

Management and Control

General partners maintain exclusive management and control of the limited partnership. A general partner’s authority is only limited by CULPA and the limited partnership agreement. On the other hand, limited partners have no authority to manage or control the organization.

Personal Liability

General partners are personally liable for the debts of the partnership. Limited partners are shielded from personal liability except for their investment in the limited partnership. However, a limited partner’s protection from personal liability will be lost if the limited partner participates in the management and control of the partnership.

Capitalization

Both limited partners and general partners must make a contribution to the partnership. A contribution may consist of either tangible or intangible property or other benefit to the limited partnership, such as money, services performed, promissory notes, contracts for services to be performed, or other agreements to contribute cash or property.

Continuity of Existence

Generally, the limited partnership will dissolve upon the happening of an event specific in the limited partnership agreement, or under additional circumstances enumerated in the CULPA, such as consent by the partners, disassociation, or judicial decree.

Taxation

Similar to the general partnership, the limited partnership is a separate tax-reporting entity and must file an informational tax return. In addition, all California limited partnerships must pay the same minimum $800 annual “franchise” tax required to be paid by corporations. While partnership income flows to the partners, and a general partner may deduct losses to offset income from other sources, a limited partner’s ability to deduct losses is restricted by the “passive activity” rules of the Internal Revenue Code.

Limited Liability Partnership

Definition

A registered limited liability partnership (LLP) is an association of two or more persons licensed to practice architecture, public accountancy or law, carried on as co-owners of a business for profit, other than a limited partnership, which is properly formed and registered, maintains the minimum level of error and omissions security, and satisfies one of the following requirements:

  • Each of its partners are licensed to practice law, architecture or accounting in California
  • The partnership is licensed or registered under the laws of California to engage in the practice of architecture, public accountancy or the practice of law.
  • The partnership is related to a registered LLP that practices law, architecture or accountancy, and provides services related or complementary to that registered LLP or foreign LLP.

In essence, an LLP is a general partnership which merely affords special liability protection to the general partners.

Management and Control

Each partner is an agent for the partnership, as long as the partner is acting for the purpose of conducting partnership business. Thus, to the extent limited by the partnership agreement, the partners share equal management and control.

Personal Liability

In the LLP, partners will not be personally liable for the partnership debts. However, partners will be personally liable to third parties based on their own tortious conduct or malpractice.

Capitalization

As in a general partnership, a limited liability partnership is simply a form of co-ownership of business assets by two or more persons. The name of an LLP should indicate the business is operating as an LLP.

Continuity of Existence

The limited liability partnership will continue as long as the statutory requirements are met; such as the continuous maintenance security for errors and omissions and conditions set forth in the code or partnership agreement are not triggered.

Taxation

Similar to the general partnership, the limited liability partnership is a separate tax-reporting entity which must file an informational return, and the partners are taxed based upon their individual proportionate share of the partnership’s income and losses.

Limited Liability Company

Definition

A limited liability company (“LLC”) is a hybrid between a corporation and partnership in that it combines the “pass-through” tax treatment of a partnership with the limited liability accorded corporate shareholders. Like a corporation, which can have as few as one shareholder, an LLC requires only one “member.” An LLC is recognized as a legal entity, separate and apart from its members, i.e., its owners. A business required to be licensed under the Business and Professions Code cannot operate an LLC, unless expressly authorized by statute. An LLC is formed by filing Articles of Organization with the Secretary of State, and the members entering into either an oral or written operating agreement.

Although LLCs were created to facilitate small businesses and appear to offer flexibility and fewer formalities while still affording members and managers protection from personal liability, there is little interpretive case law regarding this form of entity. LLCs are currently an evolving business entity and great care must be taken to satisfy all statutory requirements. Thus, business owners who choose to form an LLC must understand that the decisions of the courts in the future may result in an LLC not affording members the protection from personal liability that a corporation offers.

Management and Control

Unless the Articles of Organization provide for centralized management by managers, the management of an LLC is vested in all of its members, and an LLC member’s management and control rights are similar to that of a general partner. However, the right to management and control may be vested in a centralized management if provided for in the Articles of Organization. Members may be either natural persons or some other business entity form.

Personal Liability

Generally, only the LLC can be held responsible for the entity’s debts, and member(s) and/or manager(s) of an LLC are not personally liable. However, both the members and managers may be liable for unpaid taxes and actions in breach of their duties to the company and its members. An important distinction between an LLC and a corporation is that an LLC’s failure to hold meetings and observe related formalities is not considered a factor in establishing an LLC member’s alter ego liability where the Articles of Organization or operating agreement do not expressly require such meetings. However, failure to conduct meetings and create minutes for those meetings may severely hamper a member or manager’s ability to defend against a claim for breach of fiduciary duty.

Capitalization

A member’s capital contribution to an LLC may consist of money, property, services rendered, or a binding obligation to contribute any of these, as provided in the articles or operating agreement. Thus, unlike a corporation, capital may be contributed through the promise of future services or by a promissory note secured by the member’s shares in the LLC. Also, since membership interests may be deemed to be securities, state and federal securities laws must be considered.

Continuity of Existence

An LLC continues to exist until the occurrence of a time or event specified in the articles, an event specified in the written operating agreement, by a vote of a majority of the interest of the members or an entry of a judicial decree. Withdrawal of a member of the LLC does not affect the LLC’s existence, unless it is a single member LLC. Like a corporation, once an LLC dissolves, a certificate of dissolution must be filed with the Secretary of State’s office.

Taxation

An LLC with at least two members can elect to be classified as either an association (i.e., corporation) or a partnership, and an LLC with only one member can elect to be classified as an association or to be disregarded as an entity separate from its owner (i.e., a sole proprietorship). In California, in addition to the minimum franchise tax, an LLC must also pay a graduated annual base for all income of $250,000 or more from all California sources.

Corporation

Definition

A corporation is a distinct legal entity, existing apart and recognized separately from its owners or shareholders, and has all the powers of a natural person, including the rights to own property, sue in its corporate name, and make contracts. While corporations are governed by the General Corporations Law [Corporations Code § 100 et seq.], the rights and obligations of its shareholders and directors may be altered to some extent by agreement. Because of the protection a corporation affords its shareholders, formation of corporations require certain formalities be adhered to, such as filing Articles of Incorporation with the Secretary of State, the creation of bylaws, the issuance of shares, maintenance of shareholders’ and directors minutes, etc.

Management and Control

Generally, a corporation is managed and controlled by a board of directors and officers. The directors are elected by the shareholders, and officers are appointed by the board of directors. While the governing documents may set forth limits on the authority of directors and officers, the day-to-day operation of a corporation is generally empowered in the hands of its officers. However, shareholders may serve on the board of directors and be appointed as officers.

Personal Liability

The primary reason a business incorporates is to shield the shareholders from personal liability. Thus, if the corporation is properly formed and operating, shareholders, directors and officers are not legally responsible for corporate liabilities. However, the veil of protection offered to shareholders may be pierced if the corporation fails to adhere to statutory formalities.

Capitalization

A corporation must make a good faith effort to assure the initial capitalization is adequate for the proposed business (i.e. the amount necessary to meet the reasonably anticipated expenses of the corporation until such time as the corporation is profitable). There are limits on the consideration for which a corporation may issue its shares. Shares may be issued only for money paid, past services actually rendered to the corporation, debts or securities canceled, and property transferred to the corporation.

Continuity of Existence

Unless the Articles of Incorporation provide otherwise, a corporation will exist until voluntarily or involuntarily dissolved.

Taxation

With the exception of a corporation which has elected to be taxed under Subchapter S of the Internal Revenue Code, a regular business corporation (as differentiated from a professional corporation, discussed below) is generally considered a separate taxable entity and must pay federal and state taxes. As a result, a corporation’s income is subject to double taxation. For instance, a corporation will pay taxes on its profits, and the individual shareholders will pay taxes on the corporation’s after-tax profits, which are paid to the shareholders in the form of dividends.

Subchapter C Corporation

A general business corporation which has not made a special election under Subchapter S of the Internal Revenue Code is taxed under Subchapter C of the Internal Revenue Code in accordance with a corporate tax rate schedule.

Subchapter S Corporation

An election under Subchapter S of the Internal Revenue Code only affects how a corporation will be taxed. A regular business corporation which has made an election to be taxed under Subchapter S of the Internal Revenue Code is taxed as if it were a partnership. The Subchapter S corporation is an entity existing for tax purposes. To qualify as an S corporation, the following requirements must be met (subject to a few exceptions):

  • The number of shareholders must be no greater than 100 (Federal law provides for 100, however it is recommended that there be no more than 35, in order to qualify for other exemptions in California);
  • Shareholders must be individuals;
  • The S corporation must be a domestic corporation;
  • The S corporation may not be a member of an affiliated group of corporations; and,
  • The S corporation must only have one class of stock

Professional Corporation

A regular business corporation which renders professional services in a single profession under a certificate of registration issued by the governing board which regulates the profession may form a professional corporation. The shareholders of a professional corporation are generally limited to licensed individuals in that profession and are afforded protection from liability, as long as the liability is not related to professional negligence. Directors and officers must also meet licensing requirements, as set forth in the Moscone-Knox Professional Corporation Act. The professions which qualify are limited to accounting, architecture, audiology, medical acupuncture, chiropractic, dental, law, licensed clinical social worker, marriage, family and child counselors, nursing, optometry, pharmacy, physical therapy, physicians (including naturopathic doctors, podiatry and osteopathic), physicians’ assistants, psychological, speech language pathology, and veterinary medicine.