Business Entity Structures
Everyone has probably noticed that companies’ names often end in abbreviations such as “Inc.”, “LP”, “LLC”, “Corp.”, etc., but many people have only a vague idea what these designations actually mean. Yet, if you want to start a new company, choosing the form of that company is a fundamental and consequential decision that is best to be made at the outset, when you may be required to file papers with the California Secretary of State to create the company. Today I will explain some of the features of each type of entity, and the consequences that follow from choosing each type. This summary is based on California law, but the law governing the formation of business entities may vary from state to state.
A sole proprietorship, also known as fictitious name or DBA is the least formal of business entities, and is usually operated by a single individual (the proprietor). That individual has sole ownership and control of the enterprise, but is also directly responsible for its taxes and liabilities.
A corporation is an entity with a legal existence separate from its owners (the shareholders). Because a corporation is legally akin to a separate “person”, its owners are generally shielded from personal liability for the corporation’s actions. A corporation will pay taxes on its profits, and its owners will then pay taxes on payments they receive from the corporation. When you see “corp.”, “inc.”, “co.”, or “ltd.” at the end of a company’s name, that company is likely a corporation. You may have heard people refer to “C corporations” and “S corporations”. The key difference here lies in how the corporations are taxed (as well as the number of owners — an S corporation must have no more than 100 shareholders). All California corporations begin life as C corporations and will remain so, unless the shareholders elect to convert the company into an S corporation.
A partnership (general “GP” or limited “LP”) consists of at least two persons who have become partners to operate a business for profit. Generally, the partners themselves will be liable for the GP’s actions and obligations. A limited partnership (or “LP”) is different from a general partnership in that an LP must have at least one “general partner” that controls the partnership and faces liability for the LP’s actions and obligations, while other partners may be “limited partners” whose liability will be reduced in accordance with their reduced roles in operating the business. Like a GP or an LLC, an LP does not pay taxes on its own profits; taxes are paid by its partners following distribution of their shares of the profits. An LP is formed by filing papers with the Secretary of State.
A limited liability company (or “LLC”) is a hybrid entity that mixes characteristics of partnerships and corporations. The owners of an LLC are referred to as its “members”, and while they are shielded from personal liability (like corporate shareholders), they are taxed directly for their portions of the LLC’s profits, like partners in a general partnership; the LLC itself does not pay taxes (aside from an annual fee). The members of an LLC will enter into an “operating agreement” which will govern how the LLC will operate, and the members may appoint themselves or others as “managers” of the LLC. The operating agreement may allow or restrict the ability of the members to sell their membership interests in the LLC to other persons. Papers must be filed with the Secretary of State’s office to form an LLC.
Before you decide what form of business is best for you, you should consult with an attorney (and possibly a CPA or other financial advisor) to discuss which kind of entity is best for you, depending on your needs with regard to taxation, management of daily operations, and exposure to liability for debts and obligations of the business.
© 2017 Dr. Dariush Adli