If you are an entrepreneur starting a business in California, you have a myriad of decisions to make, including the important choice of which type of entity to form. Choosing the proper entity for your particular business is vital for ensuring proper liability protection, tax structure, and management. This article is a brief overview of the differences between the various entities you can choose when organizing your business. This first part focuses on corporations, and the second part will discuss other entities.
C-corporation
Ownership
- One or more shareholders
- No restrictions on the types of owners
Form of Equity
- Shares held by shareholders – may have multiple classes and series of shares with different rights and preferences
Formation Document
- Articles of incorporation filed with the Secretary of State
Governing Documents
- Articles of incorporation and bylaws
- Bylaws are typically adopted by the incorporators or the initial directors
- Shareholders or the board of directors may adopt, amend, or repeal bylaws
Liability
- Shareholder liability is generally limited to consideration paid for shares
- Shareholders are typically not responsible for a corporation’s liabilities
Management
- Typically governed by a board of directors led by a chairperson
- The board of directors supervise officers, who manage the day-to-day activities of the company
Taxation
- Subject to two levels of tax on income: at the entity level when earned and at the stockholder level when distributed
S-corporation
Ownership
- One to 100 shareholders
- Only US citizens/residents, certain trusts, and tax-exempt organizations can be shareholders (with limited exceptions)
Form of Equity
- Shares held by shareholders – only one class of shares permitted (but differences in voting rights among shares are permitted)
Formation Document
- Articles of incorporation filed with the Secretary of State
- Timely S-corporation election on IRS form 2553
Governing Documents
- Articles of incorporation and bylaws
- Bylaws are typically adopted by the incorporators or the initial directors
- Shareholders or the board of directors may adopt, amend, or repeal bylaws
Liability
- Shareholder liability is generally limited to consideration paid for shares
- Shareholders are typically not responsible for a corporation’s liabilities
Management
- Typically governed by a board of directors led by a chairperson
- The board of directors supervise officers, who manage the day-to-day activities of the company
Taxation
- “Pass-through” entity for tax purposes – generally does not pay entity level tax
- Generally, only the compensation income paid to the stockholder-employee is subject to employment tax
- Any other income is not subject to employment tax, which often results in substantial employment tax savings for the owners of an S-corporation
California Close Corporation
A California close corporation is similar to the S-corporation except it cannot have more than 35 shareholders. The primary benefit of the close corporation is that the management requirements and formalities are much less strict, but the owners still retain the benefit of limited liability. In addition, the shareholders act as managers of the company, and may enter into a shareholders’ agreement as a governing document. This simplicity is ideal for most small businesses. A close corporation can be converted to a more suitable form if the business outgrows the shareholder limitation.
Professional Corporation
Professional corporations are limited in purpose and the shareholders must be licensed professionals to the professional services for which it was formed (doctors, lawyers, public accountants, and engineers). A professional corporation limits the liability of its owner or owners from personal liability for the malpractice of others and from acts unrelated to the owners’ profession. It does not, however, protect the owners from personal liability for their own malpractice.
Nonprofit Corporation
Most California charities are organized as nonprofit corporations. There are three common types of nonprofits: public benefit corporations, mutual benefit corporations, and religious corporations. A public benefit corporation must be formed for public or charitable purposes, may not be organized for the private gain of any person, and often qualifies for exemption from income tax.
Before forming an entity, you should consider consulting with the following advisors:
- Employee benefits attorney to advise the types of retirement plans, health and welfare plans, and other employee benefits that can be offered to employees and business owners;
- Tax specialist familiar with both state and federal taxation issues;
- Federal and California securities specialists for capital raising considerations; and
- Legal counsel that practice in any other areas specifically affecting the business (for example, licenses and permits)
Contact us for more information about how to best organize your business by e-mailing us at info@mnklawyers.com.
This material is provided for informational purposes only. It is not intended to constitute legal advice, nor does it create a client-lawyer relationship between MNK Law and any recipient. Recipients should consult with counsel before taking any actions based on the information contained within this material.
