When people start a business from scratch, most take the easiest path: organizing as a sole proprietorship. This type of business entity is very simple and easy to operate. There are no foundational documents to file with the Secretary of State and no fees to pay. You only need a license if the type of business you are operating requires one. You only need an employer identification number if you plan to have employees. There are basic legal requirements, but they are minimal.
When you form a sole proprietorship, you and the business are considered the same legal entity. That means the profits from the business are taxable as your personal income.
The downside of being considered the same legal entity as your business is that any business debts or liabilities that arise are yours, as well. If your product were to injure someone, for example, you could be held personally responsible for any damages not covered by insurance.
A general partnership is essentially the same business structure as a sole proprietorship but with two or more owners. Each owner’s share of the profits is considered their personal income for tax purposes. Each partner is fully liable for business debts and other liabilities of the partnership.
As your business becomes more complex, consider a new business entity
If your business is beginning to take off, you may be considering adding employees or seeking out investment capital. At this point, a sole proprietorship or general partnership may no longer be your best option. A new business entity can offer tax advantages and a shield from business liability.
When choosing a new business entity, consider your desired tax structure, your management style, whether you want to sell shares, whether you need a board of directors and your tolerance for risk. An experienced business law attorney can help you clarify your goals and advise you on the best structure in your particular circumstances.
Beyond sole proprietorships and general partnerships, the most common business entities are the limited liability company (LLC) and the corporation. There are several types of corporations, as well, including the C-corporation, the S-corporation and the professional corporation.
An LLC is generally simpler to operate than a corporation because it does not require a board of directors, board meetings, stock, corporate taxes or complex corporate governance. It shields the owners from personal liability for business debts and losses. An LLC is not, however, a separate tax entity, so the owners must pay personal income tax on their share of the profits.
A corporation, on the other hand, is considered a separate entity for tax purposes, meaning that it pays its own taxes. The precise method of taxation depends on which type of corporation you set up. Corporations also shield the owners (shareholders) from personal liability for business issues.
Setting up a corporation or an LLC does require registering with the Secretary of State and paying a fee. Additionally, each entity requires particular documents to be filed. In the case of an LLC, articles of organization, an operating agreement, and a statement of information are required. Corporations require articles of incorporation and bylaws to be filed, a board of directors to be named and stock to be issued.
There are other business entities to choose from, but most companies opt for either a corporate or LLC structure. Your business attorney can explain which structures are available to you based on the type of business you are in, how each is set up, and how to operate them in compliance with California law.